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Dartig Co is a stock-market listed company that manufactures consumer products and it is planning to expand its existing business. The investment cost of $5 million will be met by a 1 for 4 rights issue. The current share price of Dartig Co is $2.50 per share and the rights issue price will be at a 20% discount to this. The finance director of Dartig Co expects that the expansion of existing business will allow the average growth rate of earnings per share over the last four years to be maintained into the foreseeable future. 

The earnings per share and dividends paid by Dartig over the last four years are as follows:

  20X3  20X4  20X5  20X6  20X7 
Earnings per share (cents)  27.7 29 29 30.2 32.4
Dividend per share (cents)  12.8 13.5 13.5 14.5 15

 

Dartig Co has a cost of equity of 10%. The price/earnings ratio of Dartig Co has been approximately constant in recent years. Ignore issue costs.

Requirements:

a
  1. Calculate the theoretical ex rights price per share prior to investing in the proposed business expansion. (3 marks)
  2. Calculate the expected share price following the proposed business expansion using the price/earnings ratio method. (3 marks)
  3. Calculate effect on shareholders wealth where revised share price is calculated using P/ E method (3 marks)
  4. Calculate share price using DVM (3 marks)
Marks: 12
b
  1. Discuss whether the proposed business expansion is an acceptable use of the finance raised by the rights issue, based on the theoretical ex-right price, and evaluation of wealth of shareholders.
  2. Discuss why the price calculated based on P/E ratio and the price calculated based on dividend valuation model are different?
Marks: 8

Answers submitted

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