Evaluate the fair value of the stock, Finance Basics

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Lavista Ltd is a leading music entertainment company in the country and the stocks of the company are actively traded in the stock exchange. For the year just ended few days back, the company has reported an earnings per share of Rs 10 and has paid a dividend of Rs 4 per share. The company has been following this payout ratio of 40% during last few years. The retained earnings are reinvested in new projects. The equity shareholders expect a minimum return of 20% from the investments of equity.

Required:

Evaluate the fair value of the stock under each of the given conditions:

i. Consider the company invests all the retained earnings in projects that yield returns of 20%.

ii. Consider the company invests all the retained earnings in projects that yield returns of 20% but now decides to decrease the future payout ratio from 40% to 20%.

iii. Consider the company invests all the retained earnings in projects that yield returns of 30%. Payout ratio remains at 40%.

iv. Assume the company invests all the retained earnings in projects that yield returns of 30% but finds that it can not have adequate projects if it retained 60% of the profit. Thus the company now decides to increase the future payout ratio from 40% to 50%.


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