Leyburn plc currently generates profits before tax of £10 million, and proposes to pay a dividend of £4 million out of cash holdings to its shareholders. The rate of corporation tax is 30 per cent. Recent dividend growth has averaged 8 per cent p.a. It is considering retaining an extra £1 million in order to finance new strategic investment. This switch in dividend policy will be permanent, as management believe that there will be a stream of highly attractive investments available over the next few years, all offering returns of around 20 per cent after tax. Leyburn’s shares are currently valued ‘cum-dividend’. Shareholders require a return of 14 per cent. Leyburn is wholly equity-financed.
(a) Value the equity of Leyburn assuming no change in retention policy.
(b) What is the impact on the value of equity of adopting the higher level of retentions? (Assume the new payout ratio will persist into the future.)