1 ( Examination level ) Guff plc, an all-equity firm, has the following earnings per share and…

1 (Examination
level)
Guff plc, an all-equity firm, has the following earnings per share and dividend
history (paid

annually).

This years dividend has just been paid and the next
is due in one year. Guff has an opportunity to invest in a new product, Stuff,
during the next two years. The directors are considering cutting the dividend
to 4p for each of the next two years to fund the project. However, the dividend
in three years can be raised to 10p and will grow by 9 per cent per annum
thereafter due to the benefits from the investment. The company is focused on shareholder
wealth

1 (Examination
level)
Guff plc, an all-equity firm, has the following earnings per share and dividend
history (paid

annually).

This years dividend has just been paid and the next
is due in one year. Guff has an opportunity to invest in a new product, Stuff,
during the next two years. The directors are considering cutting the dividend
to 4p for each of the next two years to fund the project. However, the dividend
in three years can be raised to 10p and will grow by 9 per cent per annum
thereafter due to the benefits from the investment. The company is focused on shareholder
wealth maximisation and requires a rate of return of 13 per cent for its
owners.

a If the directors chose to ignore the investment
opportunity and dividends continued to grow at the historical rate what would
be the value of one share using the dividend valuation model?

b If the investment is accepted, and therefore
dividends are cut for the next two years, what will be the value of one share?

c What are the dangers associated with
dividend cuts and how might the firm alleviate them?

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