Briefly discuss the disadvantages of the constant growth dividend model as a valuation mode

QUESTION ONE
(a) State the circumstances under which it would be advantageous to lenders and to borrowers from the issue of:

(i) Debentures with a floating rate of interest. (4 marks)
(ii) Zero-coupon bonds. (4 marks)
(Ignore taxation)

(b) (i) Briefly discuss the disadvantages of the constant growth dividend model as a valuation model. (4 marks)

(ii) The dividend per share of Mavazi Limited as at 31 December 2000 was Sh.2.50. The company’s financial analyst has predicted that dividends would grow at 20% for five years after which growth would fall to a constant rate of 7%. The analyst has also projected a required rate of return of 10% for the equity market. Mavazi’s shares have a similar risk to the typical equity market.

Required:
The intrinsic value of shares of Mavazi Ltd. As at 31 December 2000.
(8 marks)
(Total: 20 marks)

QUESTION TWO
(a) The management of Furaha Packers Ltd. is planning to carry out two activities at the same time to:
(i) determine the best credit policy for its customers
(ii) find out the optimal level of ordering orange juice from its suppliers.

The following data have been collected to assist in making the decisions:

1. Annual requirements of orange juice are 2,100,000 litres
2. The carrying cost of the juice is Sh.8 per litre per year
3. The cost of placing an order is Sh.1,400.
4. The required rate of return for this type of investment is 18% after tax.
5. Debtors currently are running at Sh.60 million and have an average collection period of 40 days.
6. Sales are expected to increase by 20% if the credit terms are relaxed and to result in an average collection period of 60 days.
7. 60% of sales are on credit.
8. The gross margin on sales is 30% and is to be maintained in future.

Required:
(i) Use the inventory (Baumol) model to determine the economic order quantity and the ordering and holding costs at these levels per annum. (8 marks)
(ii) Determine if the company should switch to the new credit policy. (4 marks)

(b) The Apollo Credit Collection Company Ltd. employs agents who collect hire purchase instalments and other outstanding amounts on a door to door basis from Monday to Friday. The agents bank their collections at the close of business everyday from Monday to Thursday. At the close of business on Friday the week’s bankings are withdrawn and, together with Friday’s collections, are remitted to the head office. The takings are evenly spread daily and weekly. The budget for the next year shows that total collections will amount to Sh.26 million. The bankings are used to reduce an overdraft whose interest rate is 19%.

The collection manager has suggested that instead of banking collections, they be remitted daily to the head office by the collectors.

Required:
Determine the increase in annual interest if the collection manager’s suggestion was adopted. (8 marks)
(Total: 20 marks)

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