Question

MNO Corp. has a market capitalization of $13,500,000 and has 500,000 shares outstanding. MNO currently pays a $2 per-share dividend. Bob currently owns 100 shares of MNO. Answer the following questions. Assume no taxes.

a. What is the value of Bob’s investment after the dividend is paid (ie cash from the dividend plus share value)? Keep in mind the share price change after the dividend is paid.

b. Bob would prefer to receive a $1 per-share dividend. Show how Bob could achieve an equivalent cash flow while still invested in MNO. Also show that Bob’s investment in MNO has the same value as in part (a).

c. Bob would prefer to receive a $3 per-share dividend. If it is possible, show how Bob could achieve an equivalent cash flow while still invested in MNO. Also show that Bob’s investment in MNO has the same value as in part (a).

d. Now assume Bob pays a 15% tax on dividends. Repeat (a), (b), and (c). Are the results different? Explain.

e. What are two other ‘real-world’ factors that were ignored in a), b), and c) that would alter the results? Explain.

Answer 1

Market capitalization of the company=$13,500,000
Number of shares outstanding=500000
Price per share=Market capitalization/Number of shares outstanding=13500000/500000=$27
Total dividend payment=Dividend per share*Number of shares outstanding=2*500000=$1000000
Market capitalization after dividend payment=$13500000-$1000000=$12500000
Price per share after dividend payment=$12500000/500000=$25

Part a:
Number of shares Bob owns=100
Value of the investment made by Bob=100*Per share dividend +100*Price per share after dividend payment
=100*2+100*25=$2700

Part b:
For $1 dividend per share:
Total dividend payment=Dividend per share*Number of shares outstanding=1*500000=$500000
Market capitalization after dividend payment=$13500000-$500000=$13000000
Price per share after dividend payment=$13000000/500000=$26
Now, the share price=$26
Value of the new investment (with 100 shares)=100*Per share dividend +100*Price per share after dividend payment
=100*1+100*26=$2700
This shows how Bob could achieve an equivalent cash flow (of $2700) while still invested in MNO.

Part c:
For $3 dividend per share:
Total dividend payment=Dividend per share*Number of shares outstanding=3*500000=$1500000
Market capitalization after dividend payment=$13500000-$1500000=$12000000
Price per share after dividend payment=$12000000/500000=$24
Now, the share price=$24

Value of the new investment (with 100 shares)=100*3+100*24=$2700

Part d:
Value after 15% tax on dividends.
Case a: (100*$2)*(1-15%) + 100*$25=$2670
Case b: (100*$1)*(1-15%) + 100*$26=$2685
Case c: (100*$3)*(1-15%) + 100*$24=$2655
Yes, the results are different due to the tax effects. Bob will make higher profits in case b.

Part e:
The two other ‘real-world’ factors that were ignored are:
i)A company declares dividend based on the net income and not on the basis of price per share.
ii)Preference of dividend amount per share (like $1 or $2 or $3 per share dividend) is normally not offered.