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Homework answers / question archive / Question No 3
Question No 3. (Marks 4) Sahara Inc., was founded nine years ago by brother and sister Fatema and Muhanad Al Balushi. The company manufactures and installs commercial heating, ventilation, and cooling units. Sahara Inc. has experience rapid growth because of a proprietary technology that increases the energy efficiency of its units. The company is equally owned by Fatema and Muhanad. The original partnership agreement between the siblings gave each 50,000 shares of stock. In the event either wished to sell stock, the shares first had to be offered to the other at a discounted price. Although neither sibling wants to sell, they have decided they should value their holdings in the company. To get started, they have gathered the following information about their main competitors: EPS DPS Earnings per share Dividend per share Arctic Inc. 50.x2 $0.16 Heating & Cooling Inc. $1.32 $0.52 Breese Inc. S-0.47 $0.40 Industry Average 50.56 $0.36 Stock price ROE R Return Required equity SI5.19 11% 10% $12.49 $11.47 513.05 139 Expert Breese Inc. negative earnings per share were the result of an accounting wright-off last year. Without the wright- off, carnings per share for the company would have been $0.97. Last year, Sahara Inc., had an EPS of $4.32 and paid dividend to Fatema and Muhanad of $54,000 each. The company also had a return on equity of 25%. The siblings believe that 20% is an appropriate required return for the company: 1. Assuming Sahara Inc., use the Zero Growth model, what is the value of share of stock today (P.)? Compare with stock prices for other companies and the industry average and give recommendations on changing dividend policy. 2. To verify the calculations, Fatema and Muhanad have hired Josh Smith as a consultant. Josh has examined the company's financial statements, as well as examining its competitors. Although Sahara Inc., currently has a technological advantage, his research indicates that other companies are investigating methods to improve efficiency Josh believes that the required return used by the company is too high. He believes the industry average required return is more appropriate. Under this assumption, what is your estimate of Sahara stock price today? Do you agree with Josh's analysis?
4
What are the advantages of each of below methods? Which method are you likely to accept?
- payback period
- average rate of return on initial investment
- net present value (NPV)
3
Part 1)
Dividend per share (DPS) = Dividend paid to each shareholders /Number of shares held by each shareholders = 54000/50000 = $1.08
Value of share of stock today = DPS/Required return = $1.08/0.2 = $5.40
All other companies & industry average has expected growth in EPS & DPS, but in sahara Inc, we taken zero growth model for stock valuation.
Required dividend to match with average industry price = Industry average stock price*required return of Sahara Inc = $13.05*20% = $2.61
From EPS of $4.32 distribute $2.61 as dividend to shareholders, so that our stock price may be similar to industry average.
Part 2)
Sahara stock price today = DPS/Required return of industry average = $1.08/0.117 = $9.23
Every investor wants average industry return plus return on extra risk taken by them. If Sahara Inc, has same risk like industry then industry required return can be appropriate required return of Sahara Inc.
4
Advantages of payback period are as follows-
A. It will be helpful in selection of projects which are repaying their initial investment within the payback period acceptable to the company.
B. Determination of payback period is easy and it is not a complex process.
C. It will be helpful in reducing the risk of losses.
Advantages of average rate of return on initial investment-
A. it will be primary focusing upon the rate of return and which is most desired by the investor
B.it has the flexibility of being adopted within any time frame and it can be extended to a longer time period also.
C. Calculation of average rate of return on initial investment is most easy and straight forward.
Advantages of net present value method are as follows-
A. Net present value method will be providing for time value of money and it will be properly discounting the risk associated with investment
B. it also incorporates the reinvestment options within calculation of Net present value
C. It is highly compatible and comprehensive method.
D. It can be customised and it is simple to use and it will be helpful in selecting of the best project
if I will have to adopt one method out of all three methods, then I will be selecting the net present value method because it will be incorporated for the time value of money and it can be applied under various circumstances when there will be a nonuniform cash flows and there will also be reinvestment assumptions associated with it so it will be helpful in selection of the best project out there when there will be a different risk associated with external environment.
