Leyburn plc currently generates profits before tax of £10 million, and proposes to pay a dividend of £4 mil- lion 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 sha r es a r e cur r ently valued ‘cum-dividend’. Sha r eholders r equi r e a r eturn of}

^{14 per cent. Leyburn is wholly equity-financed.}

Required

(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 r etentions? (Assume the new}

^{payout ratio will persist into the futu r e.)}