Question

Equity markets and share valuation

Paul and Martin Constructions was founded 5 years ago by siblings Paul and Martin. The company constructs prestige homes in the Gold Coast region of Queensland. Paul and Martin Constructions has experienced rapid growth because they provide high quality new homes at affordable prices. The company is equally owned by Paul and Martin. The original partnership agreement gave each sibling 50,000 shares.

Last year, Paul and Martin Constructions had earnings per share (EPS) of $3.15 and paid a dividend to Paul and Martin $45,000 each. The company also had a return on equity of 17%. The siblings believe that 15% is an appropriate required return for the company.

Required Questions:

Assuming the company continues its current growth rate, calculate the following:

1. Total earnings and dividend payout ratio.                                                                                         (5marks)

2. Retention ratio and share growth rate.                                                                                              (5marks)

3. Dividend paid last year.                                                                                                                         (5marks)

4. What is the value per share of the company’s shares?                                                                   (5marks)

5. Why does the value of a share depend on dividends?     

Please provide reference as well if possible

Answer 1

Total Dividend = 45000 *2 =90000

Total no of shares = 5000*2 =100000

Dividend per share = Total dividend / total no of shares = 90000 /100000 = 0.9 per share

Total earnings = earning per share * no of shares =3.15*100000 = 315000

Dividend payout ratio = dividend per share / earning per sahre = 0.9 / 3.15 = 0.2857

Retention ratio = 1 - dividend payout ratio = 1 - 0.2857 = 0.7143

share growth rate = retention ratio * return on equity = 0.7143 * 0.17 = 12.14%

Dividend paid last year = $ 0.9

value per sahre = dividend last year * ( 1+ growth rate) / ( required rate of return - growth rate )

= 0.9 * 1.1214 / ( 0.15 - 0.1214 )

= 35.32

Value of share depends on the future cash flows recieved so dividends are data that is readily available and also future dividends can be predicted. Hence the value of shares depends on dividends.