Consolidated Pasta is currently expected to pay annual dividends of $10 a share

Question

Consolidated Pasta is currently expected to pay annual dividends of $10 a share in perpetuity on the 1.7 million shares that are outstanding. Shareholders require a rate of return of 10% from Consolidated stock. a. What is the price of Consolidated stock? 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.)

Explanation / Answer

a) Market price per share in case of constant dividends is calculated as follows -

Price (P0) = Dividend per share / Ke = $10 / 0.10 = $100

Where, Ke = required rate of return

b) Total market value = Price per share x No. of equity shares = $100 x 1.7 million = $170 million

c) The extra amount that is to be paid is $10 per share.

Extra amount to be paid / Amount of new capital to be issued = 1,700,000 x $10 = $17 million

No. of share to be issued = Extra amount to be paid / Price per share = $17,000,000 / $100 = 170,000 shares

d) The company will pay $10 per share on the new shares, as they will be revert it to that price.

Dividends to be paid on the new shares = $10 x 170000 = $1,700,000

Since these are in perpetuity, just divide them by the required rate of return -

Present value = $1,700,000 / 0.10 = $17 million

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