QUESTION

Part A

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:

Compute the fair value of the stock under each of the following conditions:

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

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

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

v. Suppose the company can invest all the retained earnings only in project whose return is expected to be 10%. The company decides to increase the future payout ratio to 60%.

Part B

The Directors of Venus Plc are discussing the importance of the dividend policy on the market value of their firm. The Chairman considers that the dividend is important and does affect the company's market value. The Finance Director disagrees saying that the dividend policy has no impact on the company's market value.

Required:

Prepare a report that fully explains both Directors' views. Include relevant empirical research to support both views.