SHORT CASE 1 - THE WINNING POLICY

Tina has a junior colleague, Wesley. He is studying the financial information of Chatterbox Inc. when he finds that the firm follows a 100% dividend payout policy, implying a zero growth rate. Chatterbox has an EBIT of $15,000,000 with an interest liability of $5,000,000 and is subject to a tax rate of 34% on its earnings. The number of outstanding shares are 1,200,000. The required return on equity is 14% and all cash flows are perpetuties. The financial report that Wesley is studying also mentions that the firm may shift to a 70% dividend payout policy by the time the next dividend is due. The argument is that by doing this, Chatterbox will have more retained earnings that can be ploughed back in the company to serve the need to grow faster, where; Growth (g) = Retention ratio1 x actual return on equity. Wesley also notes that the Chatterbox stock is trading for its fair price, which he computes as approximately $39. He is wondering if, instead of a full payout, the policy changed to a 70% payout, would it rock the stock price? When Tina arrives at the scene, she sees Wesley lost in thought and decides to resolve his confusion. She starts by first of all checking whether Wesley has computed the correct stock price. After having done so, she demonstrates to Wesley the underlying dynamics about dividend payout, retained earnings, growth rate, the actual return on equity, the required return on equity, stock price of a firm and by extension, its value. At the end of the day, Wesley is happy to have found Tina as a senior colleague and returns home with a file that contains the entire analysis that Tina would have done for him. He then produly shows off the file to his younger sister, Anna, and passes it off as his own work. Anna is a final year student in the finance stream at the university and decides to read through the file contents after supper. Assuming yourself to be Anna, narrate what you would have read in the file.

Your narrative should include answers to the following: a) What is the current Dividend per share (DPS) for Chatterbox Inc., assuming a 100% dividend payout policy? (5 marks) b) What is the difference between required return on equity and actual return on equity? Can they be equal? Which one would be used to compute the stock price? (5 marks) c) Did Wesley compute the correct current stock price of $39, assuming a 100% dividend payout and other related assumptions about growth rate and cash flows? Show relevant workings to support your answer. Hint: Think about how to compute stock price when dividends are constant forever. (2 marks) d) If Chatterbox Inc. switches to the new dividend policy, what would be the DPS for the next period? (5 marks) e) Does the fact that Chatterbox will allow only a 70% payout from the next period, allows it grow? If so, what will be the growth rate if the firm successfully meets the investor expectation about the return on equity? (5 marks) f) Will a change in the dividend policy bring about a change in Chatterboxs stock price, if no other variable is impacted? If so, what will be the new price? Support your answer with relevant workings. Do not be shy in using the stock valuation models you would have learned in your other finance courses. Hint: Think about how to compute stock price when dividends grow at a constant rate indefinitely. (3 marks) g) If after changing the dividend policy to a 70% payout, Chatterbox grows at a 3% rate, what would be the implied ACTUAL return on equity and stock price? Does the stock price rise or fall? Why? (5 marks) h) From your workings in parts f) and g), what do you conclude about the relevance of dividend policy decisions? (5 marks)