# Mambo Leo Ltd has a cost of eq

1. Mambo Leo Ltd has a cost of equity of 10%. Currently thecompany has 250,000 shares which are quoted at the securitiesexchange at \$120 per share. The Company’s earnings per share is \$10and it intends to maintain a dividend payout ratio of 50% at theend of the current financial year. The expected net income for thecurrent year is \$3 million and the available investment proposalsare estimated to cost \$ 6 million.

Required

Using the Modigliani and Miller (MM) Model, calculate the valueof the firm if:

1. Dividend is paid
2. Dividend is not paid

Comment the results above

Let us first summarize all the given points for aneasier calculation.

Given:

Current Market Price (P0) = \$120

Cost of Equity(Ke) = 10%

Dividend at the end of the year( D1)= Dividend payoutratio * Earnings per share

= 50% * \$10 = \$5

We will first calculate the Expected price at the end of theyear i.e. P1 for both the cases (Dividend paid and not paid)

1. If Dividend of \$5 is paid

Under MM Model,

P0 = 1/ (1+ke) * (D1+ P1)

where,

P0 is the current Price

Ke is the cost of equity

D1 is the Dividend at the end of year

P1 is the price at the end of year

This implies that, P0 (1 + ke) = D1 + P1

P1 = P0 (1+ ke) – D1

= 120( 1.10) – 5

= \$127

2. If Dividend of \$5 is not paid

P1 = P0 (1 + Ke) – D1

= 120(1.10)

= \$132

CALCULATION OFVALUE OF THE FIRM UNDER BOTH THE CASES

1. If Dividend is paid

Given:

Total Earnings(Income) = \$3,000,000

Dividends paid (Outstanding shares * Dividend per share), 250,000* 5 = \$1,250,000

Retained earnings can be computed as TotalIncome – Dividends paid

= 3,000,000 – 1,250,000

= \$1,750,000

Investment cost = \$6,000,000

According to the MM model,

If the company has ‘n’ number of shares outstanding, then thevalue of the firm becomes n times the current market price i.e nP0. The nP0 is computed as:

where, Ke is the cost of equity

n is the number of outstanding share

m is the fresh shares issued for the newinvestment opportunity

P1 is the price at the end of year 1

I is the Investment cost

E is the total earnings

The fresh capital that the firm issues is the Total investmentcost less the Retained earnings

Therefore, fresh capital = 6,000,000 – 1,750,000

= 4,250,000

We computed the P1, as \$127

Fresh issue number of shares ‘m ‘ = 4250000/127

Therefore, m = 33,464.56

n + m = 2,50,000+ 33,464.56

= 283464.56

nP0 = 1/ (1+ke) * [ (n+m)P1 – I + E]

= 1/ (1.10) * [ (283464.56) *127 – 6,000,000 + 3,000,000]

= 1/ (1.1) * [ 36,000,000 – 6,000,000 + 3,000,000]

= 1/ (1.1) * [33,000,000]

= \$30,000,000

2. If Dividend is not paid

Given,

Total Earnings = \$3,000,000

If Dividend is not paid, the retention ratio would be 1.

Retained earnings = \$3,000,000

Investment cost = \$6,000,000

Therefore, fresh capital = 6,000,000-3,000,000

= 3,000,000

we computed P1 as \$132 in this case

m = 3,000,000/ 132

= 22727.27

m + n = 250,000 + 22727.27

= 272727.27

Therefore, nP0 = 1/ (1.10) * [ 272727.27(132) – 6000000 +3000000]

= 1/(1.1) * [ 36000000 – 3000000]

= \$30,000,000

COMMENTS:It can be seen that the value of thefirm comes out to be the same in both the cases i.e whether MamboLeo Ltd pays the Dividends or it does not pay the dividends. Thisis what the Modigliani and Miller approach shows, that the Dividendpolicy is irrelevant for the valuation ofthe firm.

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