QUESTION 2 (33 Marks)
(a)
Hatter Co. is expected to generate pre-tax profit of $4,683,500 this year. The board of directors have also announced that they will invest in an expansion project with a cost of $5,492,000. The project will be partially funded by a new $3,200,000 bank loan and the rest via retained profit.
At the moment, the business has 675,000 shares outstanding and a market share price of $16.20. In addition, the corporate tax rate is 20%.
i. Assuming that the firm will pay out the remaining profit as dividends after it has financed its projects, calculate the dividend payout ratio of Hatter Co. (5 marks)
ii. Determine its dividend yield. (3 marks)
iii. Assuming ceteris paribus, explain what would happen to the Hatter Co.'s share price after the ex-dividend date (relevant calculation is required here). (5 marks)
iv. Explain the theory that best describes the dividend practice of this firm. (4 marks)
(b) You are considering these 2 stocks as potential investments:
1. Red Queen Ltd is currently priced at $35. It will pay a dividend of $2.75 p.a for two years, but no dividend in the 3rd year. You plan to sell the stock at the end of the 3rd year for $45.
2. Cheshire Inc. is currently priced at $35. It does not pay any dividends. You expect it can be sold at the end of the 3rd year for $50.50.
You are in the 37% personal tax bracket. Dividends are taxed at the personal rate, but capital gains are taxed at a flat rate of 12%. Assuming a Ke of 9%, which stock is the better choice? (10 marks)
Critically discuss TWO (2) reasons when a share repurchase is better for shareholders as opposed to a cash dividend. (6 marks)
(c) Total: 33 marks
