Advanced financial management revision question and answer

A comparative study of the records of two oil companies, A Ltd. and B Ltd., in terms of their asset composition, capital structure and profitability shows that they have been very similar for the past five years. The only significant difference between the two firms is their dividend policy. A Ltd. maintains a constant dividend per share while B Ltd. maintains a constant dividend pay-out ratio. Relevant data is as follows:


Required:
a) For each company, determine the dividend pay-out ratio and the price – earnings ratio for each of the five years.

b) B Ltd‟s management is surprised that the shares of this company have not performed as well as A Ltd‟s in the stock exchange. What explanation would you offer for this state of affairs?

c) Comment on the applicability of the Simple Price/Earnings (P/E) ratio to the typical technology (IT) company with a high valuation and heavy losses.
ANSWER


b) The stock market must be responding adversely to B‟s fluctuating (uncertainty)
dividends per share policy in comparison to A‟s stable dividend policy.

The market on the whole must be reviewing the future of A more favorable than that of
B. Uncertainty of DPS for B Limited.

c) Price earnings P/E ratio analysis is a method used for share valuation. Each industry has a generally accepted bond of P/E ratios, hence to obtain price, the earnings are multiplied the P/E ratio.

Price = P/E ratio x Earnings

In the case of dot coms, the prices are very high, earnings are negative. This would imply a negative P/E ratio. Since we are unable to attach meaning to a negative P/E ratio, the model collapses and consequently, we cannot apply simple P/E ratio analysis to these companies.

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