Question

Consolidated Pasta is currently expected to pay annual dividends of $10 a share in perpetuity on the 2.1 million shares that are outstanding. Shareholders require a rate of return of 10% from Consolidated stock.

a. What is the price of Consolidated stock? (Do not round intermediate calculations.)

b. What is the total market value of its equity? (Enter your answer in millions.)

Consolidated now decides to increase next year’s dividend to $20 a share, without changing its investment or borrowing plans. Thereafter the company will revert to its policy of distributing $10 million a year.

c. How much new equity capital will the company need to raise to finance the extra dividend payment? (Enter your answer in millions.)

d. What will be the total present value of dividends paid each year on the new shares that the company will need to issue? (Enter your answer in millions.)

e. What will be the transfer of value from the old shareholders to the new shareholders? (Enter your answer in millions.)

f. Is this figure more than, less than, or the same as the extra dividend that the old shareholders will receive?

• More than

• Less than

• The same

Answer 1

a). Price of Consolidated stock
= Dividend/ Rate of return
= $10/0.1= $100

b). Total market value of its equity
= Share price*Number of Shares Outstanding
= 100*2.1 million = $210 million

c). Finance needed
= Extra payment
= $(20-10)per share* 2.1 million shares
= $21 million

d). Present value of Dividends=$ 109.09

Dividend next year = $20

Dividend thereafter = $10

Present Value = [20/1.10] + [10 / (0.10 x 1.10)] = $109.09

e). Transfer of wealth from old shareholders= 0

New total shares= Existing shares + Funds raised/Market price at the time of issue

New total shares= 2,100,000 + 21,000,000/109.09 = 2,292,501.604

New Market Value = 2,292,501.604 *109.09= $250,089,000

Existing market value = 210,000,000 < New market value. Hence, no transfer of wealth.