Vale plc has the following profit-after-tax history and dividend-per-share histo
ID: 2468341 • Letter: V
Question
Vale plc has the following profit-after-tax history and dividend-per-share history:
Two years ago the number of issued ordinary shares was increased by 30 per cent (at the beginning of the financial year t - 1). Four years ago a rights issue doubled the number of shares (at the beginning of financial year t - 3). Today there are 100 million ordinary shares in issue with a total market value of £190m. Vale is quoted on the Alternative Investment Market. Vale's directors are committed to shareholder wealth maximization.
Required
a. Explain the following dividend theories and models and relate them to Vale's policy:
i. Dividends as a residual;
ii. Signaling;
iii. Clientele preferences.
b. The risk-free return on government securities is currently 6.5 per cent, the risk premium for shares above the risk-free rate of return has been 5 per cent per annum and Vale is in a risk class of shares which suggests that the average risk premium of 5 should be adjusted by a factor of 0.9. The company's profits after tax per share are expected to continue their historic growth path, and dividends will remain at the same proportion of earnings as this year.
Use the dividend valuation model and state whether Vale's shares are a good buying opportunity for a stock market investor.
Explanation / Answer
a- i) Dividend as Residual- Under this model earning of the company first used for financing project and any remaining earning has to distributed as dividend to shareholders. Residual Dividends result in a passively-calculated dividend, which changes every year. Since the Residual Dividend Model assumes dividends and capital gains are two forms of the same value, it will not affect the market value.
ii)- Signaling- Under this policy investors will find "signals" in the managers' actions to get clues about the firm. For instance, when managers lack confidence in the firm's ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Investors will notice this and choose to sell their share of the firm. Investors can use this knowledge about signal to inform their decision to buy or sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations.
iii)- Clientele preferences- Under this approch a group of shareholders prefer dividend rather than capital growth.Clientele groups are often dictated by age as well as income level. Older or retired investors tend to prefer higher dividend income than younger shareholders, who may prefer that the company use free cash flow to fund growth rather that distribute dividends. Ultimately, dividend clienteles tend to be growth-versus-income parties.
As given in problem that Vale's directors are committed to shareholder wealth maximization. Hence they should maintain payout ratio as low as possible.
2- Risk free return =6.50%
Risk premium =5% and Beta is 0.90
Cost of Equity=(Rf+ beta*Risk premium)
= 6.50+ (0.90*5) = 11.00%
Last Dividend per Share =$5.40
Dividend CAGR Rate = (5.40/3.38)^(1/5)-1 = 9.82%
Next Dividend =5.40*(1+.0982) =$5.93
Fair Price of Stock = Next Dividend/(Cost of Equity-Growth rate)
=$5.93 /(.11-.0982) = $502.57
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