Question $5$

Seth, a UK firm, develops sites for solar and wind power. The firm's shares are owned by the founder

of Seth and a venture capitalist firm $($VC$).$ The firm's earnings after tax, for the year just ended, are

$1\mathrm{.}15$ million.

$($a$)$ The VC owns $45\%$ of Seth's shares, works closely with Seth's founder, and monitors the

management of the firm. Without this monitoring, Seth's earnings after tax would be $1\mathrm{.}0$ million instead

of $1\mathrm{.}15$ million. Assuming the annual cost of monitoring is $30,000,$ show that it is worthwhile for the

VC but would not be worthwhile for an investor who held $10\%$ of the shares.

$(6$ marks$)$

$($b$)$ The founder of Seth plans to take the firm public through an initial public offering $($IPO$).$

After the IPO Seth will have $1\mathrm{.}5$ million shares. The firm expects its earnings to grow at a rate of $8\%$ per

year for the first three years, then at $11\%$ per year in perpetuity. Seth has estimated its cost of equity at

$14\%$ and assumes this will remain the same in the future. The firm plans to pay the first dividend of

$0\mathrm{.}3$ million in $1$ year, and then dividends will grow at the same rate as earnings.

$($i$)$ Using the dividend growth model, what should Seth's share price be$?$

$($ii$)$ Is Seth likely to set the IPO price lower or higher than the price you calculated in $($i$)?$ Explain.

$(5$ marks$)$

$($c$)$ Assume that the tax treatment of capital gains is not the same as the tax treatment of dividend

income. Explain how specific groups of investors $(\text{'}$clienteles$\text{'})$ will have differing dividend policy

preferences. Should Seth take this into account when setting its dividend policy?