Question

Assume that you write a column for a very widely followed financial blog titled, “ Finance Questions: Ask the Expert.” Your job is to field readers’ questions that deal with finance. This week you are going to address two questions from your readers that have to do with dividends.

Question 1: I own 8 percent of the Standlee Corporation’s 30,000 shares of common stock, which most recently traded for a price of $ 98 per share. The company has since declared its plans to engage in a two- for- one stock split.

a. What will my financial position be after the stock split, compared to my current position? ( Hint: Assume the stock price falls proportionately.)

b. The executive vice-president in charge of finance believes the price will not fall in proportion to the size of the split and will only fall 45 percent because she thinks the pre-split price is above the optimal price range. If she is correct, what will be my net gain from the split?

Question 2: You are on the board of directors of the B. Phillips Corporation, and Phillips has announced its plan to pay dividends of $ 550,000. Presently there are 275,000 shares outstanding, and the earnings per share are $ 6. It looks to you like the stock should sell for $ 45 after the ex-dividend date. If instead of paying a dividend, the management decides to repurchase stock a. What should be the repurchase price that is equivalent to the proposed dividend? ( Hint: Ignore any tax effects.) b. How many shares should the company repurchase? c. You want to look out for the small shareholders. If someone owns 100 shares, do you think he would prefer that the company pay the dividend or repurchase stock?

Answer 1

Greetings,

Question No. 1

a.) there will be no change in your wealth post split as price will fall proportionately. Currently you own 8% of 30000 = 2400 shares trading at 98 per share. Hence total wealth before stock split is 2400 * 98 = 235200.

After stick split, no. of shares will double to 4800 and price will fall to half that is 49. So wealth post split is 4800 * 49 = 235200

b.) Now wealth would rise as price don't fall by 50% but only by 45%. So price post stock split will be 98 * (1-0.45) = 53.90 and shares will double to 4800. So wealth post split will be 4800 * 53.90 = 258720

Rise in wealth = 258720 - 235200 = 23520

% Rise = 10%

Question No. 2

Dividend per share = 550000/275000 = 2/share. Ex divudend price = 45. So pre dividend price = 45+2=47.

So repurchase of shares will be made at market price = 47 if company do not go for dividend.

Shares repurchased will be 550000/47 = 11702 shares

Given the fact that taxes are to be ignored, investors whether institutional or retail would be indifferent between dividend and repurchase of shares. As both have Nil effect on wealth that is wealth before and after remains the same.

But in practice, it is seen that dividend is exempt in hands of investors in most if the countries as company has already paid corporate taxes on the same. So investors may prefer cash dividend instead of share repurchase.

So it depends upon treatment of dividend v/s capital gains tax in a particular jurisdiction.