Question

TF, AB, & HY are all equity financed firms. They follow a 100%, 70% and 30% dividend payout policies respectively. TF expects before personal tax return of $5, AB of $4, and HY of $7 per year in perpetuity. TF’s share is selling for $40. It has beta of 1.2. AB is twice as risky as TF and HY is 80% as risky as AB. Market risk premium is 4%.

What should the current share prices of AB and HY be? Assume the marginal personal tax rate on dividends is 28% and on capital gains 23%.

Answer 1

Answer :  

(Given) Market price per share of TF (P0) = 40$ , Personal Tax return of TF(DPS) = 5$

P0 = DPS/Ke , 40 = 5/Ke

Ke = 12.5%

Calculation of rate of risk free return (Rf) ; Formula used :- Rf + B(Rm-Rf) = Ke , Given : Beta(B) of TF =1.2 & Market risk premium (Rm-Rf) = 4%

12.5% = Rf + 1.2 (4%)

Rf = 7.7%

Calculation of B (Beta) Of AB = Twice of TF = 2*1.2 = 2.4

Calculation of B (Beta) Of HY = 80% Of AB = 2.4*80% = 1.92

Calculation of Ke of AB = 7.7%+2.4*4% = 17.3% & Ke of HY = 7.7% + 1.92*4% = 15.38%

Dividend after tax of AB = 4*70% (1-28%) = 2.016 Here, Dividend payout ratio is 70%

Price of share of AB : formula used : DPS/Ke = 2.016/17.3% = 11.65 $ per share

Dividend after tax of HY = 7*30% (1-28%) = 1.512$ Here, Dividend payout ratio is 30%

Price of share of HY : formula used : DPS/Ke = 1.512/15.38% = 9.83 $