MOD004491 - Corporate Finance - Week commencing 13.03.

17
Dividend Policy

1. Consider the case of ABC Corp., a hypothetical firm. ABC has 20 million in excess
cash and no debt. The firm expects to generate additional free cash flows of 48 million
per year in subsequent years. If ABCs unlevered cost of capital is 12%, what is the
enterprise value of its ongoing operations?
Ans: The Enterprise Value is the present value of all future cash flows. In this case, it
48million
is = 400million.
12%

2. If the Board opted to pay the dividend with its excess cash for a 2 and the company
has 10 million shares outstanding, what would the stock price be before and after the
stock goes ex-dividend? Assume the record date is 14 December, so the ex-dividend
date is 12 December. Assume further that ABC has no debt and it is 100% equity
financed.
4.80
Ans: Pcum = current dividend + present value of future dividends=2 + = 42.
0.12
After the stock goes ex-dividend, new buyers will not receive the current dividend.
At this point the share price will reflect only the dividends in subsequent years, i.e.
Pex = 40. In other words, the share price will drop on the ex-dividend date, 12
December, which is equal to the amount of the current dividend, i.e. 2.

Tab. 1. Balance Sheet approach Dividend payout

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3. Supposed that ABC does not pay a dividend this year, but instead uses the 20 million
to repurchase its own shares on the open market. How will the repurchase aect the
share price?
20million
Ans: With an initial share price of 42, ABC will repurchase = 0.476
42/sh
million shares, leaving only 10 0.476 = 9.524 million shares outstanding. In this case,
the market value of ABCs assets falls when the company pays out cash, but the number
of shares outstanding falls also. The two changes oset each other, so the share price
remains the same. Another way to look at this is by considering the price of the stock
with the repurchase, Prep . Considering the new amount of shares outstanding, the
price per share is 48million/9.524million shares = 5.04per share each year. Then,
5.04
ABCs share price today with repurchase is given by Prep = = 42.
0.12

Tab. 2. Balance Sheet approach Share repurchase

4. Would an investor prefer that ABC issue a dividend or repurchase its stock? Is there
a dierence in shareholder value after the transaction? Lets assume that there is an
investor who holds 2,000 shares of ABC stock.
Ans: Under the dividend case, the investor will hold 80,000 (=40 2,000) worth
of stock and 4,000 (=2 2,000) worth of cash equalling 84,000. For the stock
repurchase, the investor will hold 84,000 worth of stock (=42 2,000). So, in either

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 case, the value of the investors portfolio is 84,000 immediately after the transaction.
The only dierence is the distribution between cash and stock holdings.

Tab. 3. Investors preference

5. Suppose that ABC pays a 2 dividend per share today. Show how an investor holding
2,000 shares could create a homemade dividend of 4.50 per share 2,000 shares =
9,000 per year on her own.
Ans: If ABC pays a 2 dividend, she receives 4,000 cash and holds the rest in stock.
To receive 9,000 in total today, she can raise additional 5,000 by selling 125 shares at
40 per share just after the dividend is paid. In future years, ABC will pay a dividend
of 4.80 per share. Because she will own 2000 - 125 = 1875 shares, the investor will
receive dividends of 1875 4.80 = 9,000 per year from then on.

6. Consider an individual investor in the highest US tax bracket who plans to hold a stock
for more than a year. What was the eective dividend tax rate for this investor? How
did the eective dividend tax rate change a year later? Suppose that the dividend tax
rate was 39% and the capital gains tax was 20% in the year of the stock purchase, but
that both taxes have been reduced to 15% in the current year.
0.39 0.20
Ans: in the year of the purchase, the eective dividend tax rate is = 23.75%,
1 0.20
which implies that for each $1 of dividend, it is only worth $0.7625 in capital gains.
0.15 0.15
However, in the current year, the eective dividend tax rate is = 0%, thus
1 0.15
the reduction helps to eliminate the tax disadvantage for this one-year investor.