Question

Cabot Vineyards has been paying a regular cash dividend of $4.80 per share each year for over a decade. The company is paying out all its earnings as dividends and is not expected to grow. There are 118,000 shares outstanding selling for $80 per share. The company has sufficient cash on hand to pay the next annual dividend.
Suppose that, starting in year 1, Cabot decides to cut its cash dividend to zero and announces that it will repurchase shares instead.
a. What is the immediate stock price reaction? Ignore taxes and assume that the repurchase program conveys no information about operating profitability or business risk.

b. How many shares will Cabot re-purchase?

c. Project and compare future stock prices for the old and new policies for the next 3 years. What is the annual return to shareholders under each of the policies?

Answer 1

a). If we ignore taxes and there is no information conveyed by the repurchase when the repurchase program is announced, then share price will remain at $80.

b). The regular dividend has been $4.80 per share, and so the company has ($4.80 x 118,000) = $566,400 cash on hand. Since the share price is $80, the company will repurchase ($566,400 / $80) = 7,080 shares.

c). Total asset value (before each dividend payment or stock repurchase) remains at ($80 x 118,000) = $9,440,000. These assets earn $566,400 per year, under either policy.

Old Policy:

The annual dividend is $4.80, which never changes, so the stock price (immediately prior to the dividend payment) will be $80 in all years.

New Policy:

Every year, $566,400 is available for share repurchase. As noted above, 7,080 shares will be repurchased at t = 0.

At t = 1, immediately prior to the repurchase, there will be (118,000 - 7,080) = 110,920 shares outstanding. These shares will be worth $9,440,000, or $85.11 per share. With $566,400 available to repurchase shares, the total number of shares repurchased will be 6,655.

Using this reasoning, we can generate the following table:

Time	Shares Outstanding	Share Price	Shares Repurchased
t=0	118,000	$80.00	7,080
t=1	110,920	$85.11	6,655
t=2	104,265	$90.54	6,256
t=3	98,009	$96.32	5,881

Note that the stock price is increasing by 6.38% each year. This is consistent with the rate of return to the shareholders under the old policy, whereby every year assets worth $8,873,600 (the asset value immediately after the dividend) earn $566,400, or a return of 6.38%.