Dragon Limited's Investment Decision: Maximizing Shareholder Wealth Through Micro-clip Production Expansion

(a) (i) The expected dividend from year 1 to year 4 is:

Year 1: $4.00 Year 2: $4.60 ($4.00 x 1.15) Year 3: $5.29 ($4.60 x 1.15) Year 4: $6.05 ($5.29 x 1.15)

(ii) The terminal value in year 3 can be calculated using the Gordon Growth Model:

Terminal value = Year 4 dividend / (required rate of return - dividend growth rate) Terminal value = $6.05 / (0.12 - 0.08) Terminal value = $151.25

(iii) The current value of one ordinary share can be calculated using the dividend discount model:

PV = (D1 / (1 + r)^1) + (D2 / (1 + r)^2) + (D3 / (1 + r)^3) + (TV / (1 + r)^3) PV = ($5.0 / (1 + 0.12)^1) + ($6.0 / (1 + 0.12)^2) + ($6.9 / (1 + 0.12)^3) + ($151.25 / (1 + 0.12)^3) PV = $126.99

(b) (i) The terminal value in year 4 can be calculated using the Gordon Growth Model:

Terminal value = Year 5 dividend / (required rate of return - dividend growth rate) Terminal value = $8.25 / (0.12 - 0.08) Terminal value = $206.25

(ii) The current value of one ordinary share can be calculated using the dividend discount model:

PV = (D1 / (1 + r)^1) + (D2 / (1 + r)^2) + (D3 / (1 + r)^3) + (TV / (1 + r)^3) PV = ($5.0 / (1 + 0.12)^1) + ($6.0 / (1 + 0.12)^2) + ($6.9 / (1 + 0.12)^3) + ($206.25 / (1 + 0.12)^3) PV = $164.20

(iii) The total cost of the new production line is $30 million, so the number of ordinary shares to be issued can be calculated as:

Number of shares = Total cost / Current value per share Number of shares = $30,000,000 / $164.20 Number of shares = 182,836 Rounded up to nearest integer: 182,837

(c) Based on the results in parts (a) and (b) above, Dragon Limited should accept to invest in the new product line if the management has an objective of maximizing shareholders’ wealth. The current value per share is higher in part (b) than in part (a), indicating that investing in the new product line and issuing new ordinary shares will increase the value of the company.

(d) (i) The current value of one bond can be calculated using the present value formula:

PV = Coupon payment x (1 - (1 / (1 + r)^n)) / r + Face value / (1 + r)^n PV = $450 x (1 - (1 / (1 + 0.08)^10)) / 0.08 + $10,000 / (1 + 0.08)^10 PV = $7,017.20

(ii) The total cost of the new production line is $30 million, so the number of bonds to be issued can be calculated as:

Number of bonds = Total cost / Current value per bond Number of bonds = $30,000,000 / $7,017.20 Number of bonds = 4,271 Rounded up to nearest integer: 4,272

(e) Assumptions of MM theory on dividend policy:

1. No taxes: The theory assumes that there are no taxes, which is not a realistic assumption in the real world.
2. No transaction costs: The theory assumes that there are no transaction costs, which is not true as there are always costs associated with transactions in the real world.
3. Perfect capital markets: The theory assumes that capital markets are perfect, which means that there are no information asymmetries or market imperfections. This is not true in the real world.
4. Investors are rational: The theory assumes that investors are rational and will always act in their best interests, which is not the case in the real world.

Limitations of MM theory on dividend policy:

1. Real-world considerations: The theory ignores real-world considerations such as taxes, transaction costs, and market imperfections.
2. No consideration of investor preferences: The theory assumes that all investors have the same preferences for dividends, which is not true in the real world.
3. No consideration of signaling effects: The theory does not consider the signaling effects of dividend payments, which can affect investor perceptions of a company's future prospects.
4. No consideration of agency costs: The theory does not consider the agency costs associated with management decisions on dividend policy, which can affect shareholder wealth.