Question: Can you explain the "for" and "against" theoretical views of the Dividend Irrelevance Theory in below company background.

TOPIC:

APP is an e-business which designs and sells computer applications for mobile phone. The company needs to raise $3,200,000 for research and development and is considering the following financing option:

APP could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of the third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent year have grown by 3% per year.

Recent financial information relating to APP is as follows:

$000

Operating profit

3,450

Interest

200

Profit before taxation

3,250

Taxation

650

Profit after taxation

2,600

Dividends

1,600

$000

Ordinary shares (nominal value 50 cents)

5,000

• The profit tax rate paid by the company is 20% per year.
• APP has a cost of equity of 9% per year, which is expected to remain constant.

Required:

1. Using the dividend valuation model, calculate the value of APP with the adoption of the financing option, and advise whether it will be acceptable to shareholders (10 marks)

Answer of no. 1

We need to ascertain the value of the company by discounting the expected future dividends at the required cost of capital which in this case is the cost of equity since the value of an investment or firm today is the present value of cash flows that investors expect to receive from it.

The book value of ordinary shares is $5,000,000

Number of shares issued=book value of ordinary shares/nominal value of each share=$5,000,000/50 cents=10,000,000

Based on the new financing option, the expected future dividends are as follows:

Year 1 diviends=$0

Year 2 dividends=$0

Year 3 dividends(dividend per share*number of ordinary shares)=25cents*10,000,000=$2,500,000

The dividends are expected to grow 4% forever, hence, the terminal value of dividends is computed thus:

Terminal value=year dividends*(1+terminal growth rate)/(cost of equity-terminal growth rate)

Terminal value=$2,500,000*(1+4%)/(9%-4%)=$52,000,000

Present value of a future cash flow=cash flow/(1+r)^n

r refers to cost of equity while n is the year in which the cash flow is expected,for instance n is for year 1 cash flow,2 for year 2 and so on.

value of the company=$0/(1+9%)^1+$0/(1+9%)^2+$2,500,000/(1+9%)^3+$52,000,000/(1+9%)^3=$42,083,999.66

value per share=$42,083,999.66/10,000,000=$4.21

Value of the company based on current dividends:

Value of the company=existing dividends*(1+dividend growth rate)/(cost of equity-dividend growth rate)

Note that the current dividends would continue for forever.

value of the company=$1,600,000*(1+3%)/(9%-3%)=$27,466,666.67

value per share=$27,466,666.67/10,000,000=$2.75

increase in value of the company be adopting financing option=$42,083,999.66-$27,466,666.67=$14,617,332.99

1. Already answered on above.
2. Critically examine the "for" and "against" theoretical views of the Dividend Irrelevance Theory (40 marks)

In this section students should demonstrate knowledge, understanding, and an ability to critically evaluate and analyse the main dividend relevance and irrelevance theoretical viewpoints. The response should be developed through use of a wide range of relevant academic literature, referenced as per Harvard referencing requirements. The inclusion and ability to integrate real-life practical business examples, addressing whether differing companies adopt a dividend relevance or irrelevance standpoint would assist in developing the response in greater depth.