Question

Mustang Ltd. Is evaluating an i) extra dividend, and ii) a share repurchase. In either case, $13,325 would be spent. Current earnings are $4.25 per share, and the share sells for $116. There are 5125 shares outstanding. Ignore taxes and other transaction fees and charges in answering the following questions. REQUIRED a. Evaluate the two alternatives [i) and ii)] in terms of the effect on the price per share and on shareholder wealth. b. What will be the effect on Mustang’s earnings per share EPS and the price-earnings ratio under the two different scenarios [i) and ii)]? c. In the real world, which of these two actions [i) or ii)] would you not recommend? Why? d. “A company’s dividend policy is not as important as its capital structure policy.” Discuss.

Answer 1

Effect of dividend distribution

EPS: No impact =4.25

Shareholder wealth = 13325 or 13325/5125 = $2.6 per share

Share price: 116-2.6 = $113.4

PE Ratio = 113.4/ 4.25 = 26.68

Share repurchase impact

Number of sharesrepurchased= 13325/116 = 115 shares

EPS = 4.25*5125/ (5125-115) = $4.35

Stock price= 116

Shareholder wealth =No impact

PE Ratio= 116/4.35 = 26.68

c. I would not recommend a share buy back. This is because it lowers the investor confidence in the company. Future returns with a share buyback is not assured. Dividends on the other hand increase investor satisfaction. Share buybacks fail when they are overvalued. Alsothey may fail if they use borrowed money for the buyback.

d. A company's dividend policy is highly important as this is the base for investor perceptions about the company. The expectations of returns from their investment drives up or down the market price of the shares of the company. If the company pays regular dividends, the investors are happy to invest and this increases the demand as well as the share price of the company.