3. Saskatchewan Fine Jewellery (SFI) is expected to earn $180,000 per year for the next two years. The firm will be liquidated at the end of Year 2 but no cash proceeds will be generated from the liquidation. The firm’s investors require 15% return. Management is considering what to do with the cash that will be generated at the end of the first year. It can pay the entire earnings in dividends (100% dividend payout policy). Alternatively, it can pay 40% in dividends (40% payout policy) and reinvest the remaining amount in a project code named JX. Project JX is expected to generate 16% return at the end of its first year of operation after which JX will be sold, and the initial investment will be fully recovered (also 1 year after acquiring JX).
1. a) What will be the firm’s value under the 100% dividend payout? (4 marks)
2. b) SFI has 20,000 shares outstanding. John is a retired teacher and owns 10% of SFI. He relies on dividends from SFI for spending. He prefers the 100% dividend policy. What would be John’s share of dividends under the 100% dividend policy? (3 marks)
3. c) What will be the firm’s value under the 40% dividend policy? (6 marks)
4. d) Management decides to adopt the 40% dividend policy and invest in JX. What would be SFI’s share price at the end of Year 1 immediately after paying the 40% of Year 1’s cash flows as dividends? (7 marks)
5. e) Under the 40% dividend policy, how many shares John must sell immediately after receiving his Year 1’s dividends to obtain his target spending income from SFI? (5 marks)