Consider thefollowing information related to two companies of the same industrya

Question

Consider thefollowing information related to two companies of the same industryas on Dec. 31, 2009.

XYZ Company

ABC Company

Share Capital(Rs.10 each)

Rs. 850,000

Rs.1,400,000

Reserves

Rs. 320,000

Rs. 500,000

RetainedEarnings

Rs. 200,000

Rs. 250,000

CurrentYear Dividend

20 % (Rs.2.0)

16 % (Rs.1.60)

Dividend GrowthRate

10%

5%

Market Price of Common Stock

Rs. 15

Rs. 12

Required:

Which company’s capitalstructure is more efficient?

Note: (Calculations are notrequired. Do your calculations in rough work and support youranswer in just one line.)

[Hint: Compare Cost of Equities ofboth companies.]

XYZ Company

ABC Company

Share Capital(Rs.10 each)

Rs. 850,000

Rs.1,400,000

Reserves

Rs. 320,000

Rs. 500,000

RetainedEarnings

Rs. 200,000

Rs. 250,000

CurrentYear Dividend

20 % (Rs.2.0)

16 % (Rs.1.60)

Dividend GrowthRate

10%

5%

Market Price of Common Stock

Rs. 15

Rs. 12

Explanation / Answer

Cost Of Equity under dividend capitalization model ===================================                   Dividendper share COE   =   ---------------------   +Growth rate                      PricePer Share                                                          Company                                                   Company                                                             XYZ                                                           ABC                                                       --------------                                               ------------ =(2.0 x 1.1 /15) +10%                     24.66%         =(1.60x 1.05/12) +5%            19%                                                                               

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