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Chapter 3

Example 5

Elbow Co is an all equity financed company with a functional currency of
British pounds (GBP). It has 10 million GBP 1 shares in issue. The directors of
Elbow Co are considering a change in dividend policy at the end of this year.

Historically the company has paid out 30% of its profits as a dividend.
However, the directors have identified a new project that they want to invest
in. The necessary funds for investment could be found by cutting the dividend
payout ratio to 10% of profits for this year only.

Forecast profits for the current year are GBP 10 million. Next year's profits will
be 15% higher if the dividend is cut and the new project undertaken.
Otherwise, profits will stay constant.

Required:

Calculate the dividend per share and the earnings per share for this year
and next year, on the assumption that:

(a) the dividend is cut and the project is invested in

(b) the dividend payout is left unchanged and the project is not
undertaken.

Solution

Current year:

The current year's profit is forecast to be GBP 10 million, so whether the
dividend is cut and the project is undertaken or not, the earnings per share
(EPS) will be

GBP 10m/10m = GBP 1.

If the dividend is cut, to 10% of profits, the dividend per share (DPS) will
therefore be 10% of this, i.e. GBP 0.10.

If the dividend is not cut, so remains at 30% of profits, the dividend per share
(DPS) will be 30% of this, i.e. GBP 0.30.

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