Question

The company has paid a constant cash dividend of 7$ on an annual basis for the last decade. For the dividend payment it used all its earnings. The business outlook is stable with no growth. Currently there are 250.000 outstanding shares at 50$ per share. The company earned again just about the right amount to pay its dividend. The CFO decides to switch instantly from cash dividends to repurchases for this year (T0). Project and compare the stock price for the old and the new policy for next year (T1).

Do the necessary calculations and fill the following table:

	New Policy			Old Policy
	Shares oustanding	Shares Repurchased	Share Price	Share Price
T0
T1

Answer 1

Solution:-

Since the dividend is equal to earnings and there is no growth in earnings, let's calculated the cost of equity as follows:

Cost of equity= Constant dividend/stock price = $7/$50 = 14%

Stock price (T0) under old policy= Expected EPS for T1/cost of equity = $7/14%= $50

Stock price (T1) under old policy= Expected EPS for T2/cost of equity = $7/14%= $50

The number of shares repurchased in T0 are as follows:

Total earnings for current year= 250,000*$7= $1,750,000

No. of shares repurchased= $1,750,000/price per share= $1,750,000/$50= 35,000 shares

Remaining shares= 250,000-35,000= 215,000 shares

Expected EPS after repurchase at T0= Existing total earnings/Revised no. of shares= $1,750,000/215,000 = $8.14 per share

Stock price (T0) under new policy= Expected EPS for T1/cost of equity = $8.14/14%= $58.14 per share

The number of shares repurchased in T1 are as follows:

Total earnings for T1= $1,750,000

No. of shares repurchased= $1,750,000/price per share= $1,750,000/$58.14= 30,100 shares

Remaining shares= 215,000-30,100= 184,900 shares

Expected EPS after repurchase at T1= Existing total earnings/Revised no. of shares= $1,750,000/184,900 = $9.46 per share

Stock price (T1) under new policy= Expected EPS for T2/cost of equity = $9.46/14%= $67.57 per share

	New Policy			Old Policy
	Shares oustanding	Shares Repurchased	Share Price	Share Price
T0	215,000	35,000	58.14	50
T1	184,900	30,100	67.57	50