Question

Please answer (d) and (e)

A company has been paying a regular cash dividend of $4.00 per share each year. It pays out all of its earnings as dividends and is not expected to grow. There are 100,000 shares outstanding trading for $80.00 per share after the payment of the $4.00 per share dividend (i.e., after the ex-dividend date; prior to the ex-dividend date, the price included the value of the dividend payment). The company has enough cash on hand to pay dividends. Suppose that the company announces that it will cut its dividend to zero and use the cash to repurchase shares.

(a) What is the immediate stock price reaction to the announcement. Ignore taxes and any signaling effect.

(b) How many shares will the company repurchase at the end of the first year?

(c) Project future stock prices under the dividend policy and the repurchase policy for years 1, 2 and 3.

(d) What is the required return on the common stock?

(e) What is the expected annual rate of increase in the stock price?

Answer 1

D) $80 is the price including the dividend payment. Therefore, after dividend payment, the share price will drop to $76 per share. Each share earns a dividend of $4 per year over $76 investment, therefore required rate of return on common stock = 4/76=5.26%

E)At t=0, the company has 8000,000 in assets (100,000*80). Every year the company has $400,000 cash, which it can use to repurchase shares. Thus in 1st year, the company can purchase 5000 shares (400000/80). Resulting in 95,000 shares outstanding at t=0. At t=1, the company has again earned $400,000 bringing its net assets back to $8,000,000, but now only 95000 shares are outstanding, resulting in price pershare =$ 84.21.

At t=1, the again purchase shares worth $400,000 I.e.4750 (400,000/84.21) shares.

Based on these calculations, the yearly share values will be:

Which means a share price increase by 5.26% per annum.

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