Question

Suppose that instead of plowing back money bank into lucrative ventures, Tencent China’s
management is going to invest in the capital market where expected return on equity (ROE) is 5%, which is below the return of 6.8% that investors could expect to get from comparable securities. It is expected to pay a dividend next year of RM0.63. Assume the zero growth value of Tencent China is RM13.51.
Required:
(a) Find the sustainable growth rates for the dividends and earnings in these circumstances.
Assume a 68.6% payout ratio. 
(b) Find the new value of the investment opportunities. Explain why this value is negative despite
the positive growth rate in earnings and dividends. 
(c) If you were a corporate raider, would Tencent China be a good target for a takeover?
(d) In your opinion, how would Tencent China’s decision to pay out a higher percentage of its earnings as dividends presently affect its future share price?

Answer 1

(a) Growth= Retention ratio(b) × return on equity(r)

Retention ratio= 1- Payout ratio

= 1- 0.686 = 0.314

Growth = 0.314× 0.05= 1.57%

(b) New Value of investment to be calculated as follows:

Cost of equity(ke) = 6.8%, g= 1.57%

= Dividend per share at next year/ ke - g

= 0.63/ 6.8 - 1.57 = RM 12.04

As Tencent china has return on equity less than cost of equity, value is less than zero growth value. company should focus on increasing payout ratio which will in turn increase the value.

(c) Considering zero growth rate as the actual market rate, Tencent china is not a good target company to takeover at this stage as its market price is more than fair price calculated in part (b) above

(d) Yes, with more dividend and less retention share price will increase in future. Higher the dividend higher the share price.