Question: Discuss the imperfections in the real world that might influence firms’ dividend policy

Question 1

Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent £10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store.

1.1 Which of the following should be included as part of the incremental earnings for the proposed new retail store and why? a. The upfront cost of demolishing the abandoned warehouse and clearing the lot is £20,000 in total. b. When the new store is operating, the market research expects a loss of sales of £100,000 in the existing retail outlet because customers who previously drove across town to shop at the existing outlet become customers of the new store instead. c. The £10,000 spent on market research to evaluate customer demand. d. Construction costs of £320,000 for the new store. e. The value of the land if it is sold in the next year is £90,000.

1.2 To construct the new store, the necessary machinery that has a 6-year life would cost £320,000. The machine will be depreciated via the reducing balance method over four years at 30% with a salvage value of £40,000. Once the machine is operating next year, Home Builder Supply is expected to generate £700,000 per year in sales, which will continue for the 6-year life of the machine. The cost of goods is 50% of its sales. The manager estimates that the operation would require £100,000 of inventory and other working capital upfront (year 0) and argues that this sum is recoverable at the end of the 6 years. Home Builder Supply’s marginal corporate tax rate is 35%. We do not consider taxes during the preparation period (year 0). Based on the information of 1.1 and 1.2, what is the total incremental cash flow if Home Builder Supply opens the new store?

1.3 Assume the discount rate is 10%, calculate the NPV of the project and decide whether Home Builder Supply should invest in the project or not. Calculate the project’s IRR and payback period. Discuss the limitations of the two techniques, respectively.

Question 2.

2.1. Studies consistently find that IPO firms underperform their matched firms in the long-term. Discuss potential explanations of the IPO long-term underperformance. Please provide evidence from the literature. (Maximum word count: 500)

2.2 What are the other three puzzles of IPO and their explanations? (Maximum word count: 500)

3. Genron Corporation decided to pay out £40 million in excess cash to shareholders this year. Genron has no debt and 10 million shares outstanding with an initial share price of £44. The unlevered cost of capital is 12%. The firm has two options. Option 1 Pay a dividend of £4 per share this year and a dividend of £4.8 per share each year thereafter. The stock price after the ex-dividend date will become £40. Option 2 Instead of paying a dividend this year, the firm uses £40 million to repurchase shares on the open market. With an initial price of £44, it can repurchase 909,090 shares.

3.1 Assume there are no other costs, what are the firm values of the two options? What is the impact of dividend policy on firm value?

3.2 Discuss the imperfections in the real world that might influence firms’ dividend policy. (Maximum word count: 350)