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Dartig Co is a stock-market listed company that manufactures consumer products and it is planning to expand its existing business. The investment cost of $5 million will be met by a 1 for 4 rights issue. The current share price of Dartig Co is $2•50 per share and the rights issue price will be at a 20% discount to this.
The finance director of Dartig Co expects that the expansion of existing business will allow the average growth rate of earnings per share over the last four years to be maintained into the foreseeable future.
The earnings per share and dividends paid by Dartig over the last four years are as follows:
2003 2004 2005 2006 2007
earnings per share (cents) 27.7 29.0 29.0 30.2 32.4
dividend per share (cents) 12.8 13.5 13.5 14.5 15.0Dartig Co has a cost of equity of 10%. The price/earnings ratio of Dartig Co has been approximately constant in recent years. Ignore issue costs.
Required:
Discuss whether the proposed business expansion is an acceptable use of the finance raised by the rights issue, and evaluate the expected effect on the wealth of the shareholders of Dartig Co.
Question is very complicated. …
can u please guide how to go about
Q1c – December 2013
Darn Co has undertaken market research at a cost of $200,000 in order to forecast the future cash flows of an investment project with an expected life of four years, as follows:
Year 1 2 3 4
Sales Revenue ($000) 1250 2570 6890 4530
Costs ($000) 500 1000 2500 1750These forecast cash flows are before taking account of general inflation of 4•7% per year. The capital cost of the investment project, payable at the start of the first year, will be $2,000,000. The investment project will have zero scrap value at the end of the fourth year. The level of working capital investment at the start of each year is expected to be 10% of the sales revenue in that year.
Capital allowances would be available on the capital cost of the investment project on a 25% reducing balance basis. Darn Co pays tax on profits at an annual rate of 30% per year, with tax being paid one year in arrears. Darn Co has a nominal (money terms) after-tax cost of capital of 12% per year.
Required:
Explain ways in which the directors of Darn Co can be encouraged to achieve the objective of maximisation of shareholder wealth. (6 marks)
Same goes with this qn…….how do I approach this qn…
Darting (part c) is not complicated – you will have done the arithmetic already in parts (a) and (b).
The TERP from part (a) is 2.40 but that ignores the investment of the money.
From part (b) the estimate of the actual share price using the PE ratio is 2.60.
Therefore the effect on the wealth of shareholders is that they will make a gain of 0.20.The only extra needed is a few points about the assumptions made and therefore the fact that the figures used might not be accurate.
For Darn (part (c)) the best is to learn from the examiners answer – I can’t really add anything to what he has written.
It is the market value of the shares that is the measure of shareholder wealth. By giving the directors share options, they are then encouraged to try and increase the share price.
Remember that the examiner always writes far more than he expects from students.
Thank you sir. Yes, the answers provided by the examiner and in the kit are far too many & detailed and complex
I hope it’s fine if I gave brief points like 5 or 6 if it’s a 5 mark qn .
It’s quite difficult to comprehend and understand the answers in the kit/examiner
If it is a 5 mark question, then aim to make 5 points. It is hard in the middle of an exam to be able to think of 5 points but always aim to be getting at least 50% on every part of every question.
Sir, the question dartig co is included in the bpp kit mock exam 2 (latest edition book).
In part c the answer compares share price using PE with share price calculated using TERP. This made sense to me as terp share price is before the expansion and PE share price is after taking into account expansion plan.
The answer also writes an alternative way if we were asked to calculate effect on total shareholder wealth and not just per share price.
So as in the first method here a similar approach should be used but it seems different.
They compare: (total shares before right issue x market value) with (total shares after right issue x PE method share price – investment amount)
This didn’t make sense to me. I would rather compare (12.5m shares x terp share price $2.4) with (12.5m share x PE share price $2.6 less $5m investment)
I don’t know if i am wrong or right, but both my and book method gives same answer, is it a co incident? If i am wrong please explain me why bpp book did it in that way, i can not get meaning of those figures.Also, The part d asks to calculate share price using dvm and also discuss the difference in current share price with that calculated through dvm.
Firstly, The dvm share price is 2.6 which is same as calculated using PE, will it always be same or this was just a co incidence?
Secondly, the share price we calculated using dvm, is this share price after proposed business expansion or without taking its effect?For the first part of your question, what you have done is fine and not a coincidence.
For the second part – DVM price will not always be the same as that calculated using a PE ratio. The price using DVM is after the expansion.
But sir If the dvm price is an after expansion share price then why would we compare it with market share price which is a price BEFORE BOTH expansion and right issue took place and give justification for it :/
comparing it with TERP (as this is after right issue) or PE share price (after both right and expansion) wpuld atleast makea sense. I am confused :/
Also, since we used previous year dividend and calculated dividend growth also with previous year’s data ,which were before expansion, i think the dvm share price is before expansion. If i am wrong then please tell me why would we compare it with market share price.The answer to part (c) does compare the new MV with the TERP – the difference is due to the use of the finance raised.
Part (d) is nothing to do with the rights issue or the expansion – it wasn’t the current market value using the dividend growth model, and an explanation of why the actual market value is not the same.
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