Question

Hors d’Age Cheeseworks 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 111,000 shares outstanding selling for $80 per share. The company has sufficient cash on hand to pay the next annual dividend at t = 1.

Suppose that, starting in year 1, Hors d’Age 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.

	Increase
	Decrease
	Remain the same

b. How many shares will Hors d’Age purchase? (Round your answer to the nearest whole number.)

Number of shares repurchased            

c. Project and compare future stock prices for the old and new policies. (Do not round intermediate calculations. Round your old policy answers to the nearest whole number and your new policy answers to 2 decimal places.

	Share Price
Year	Old Policy	New Policy
1	$	$
2	$	$
3	$	$

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 111,000) $532,800 cash on hand. Since the share price is $80, the company will repurchase ($532,800/$80) 6,660 shares.

c). Total asset value (before each dividend payment or stock repurchase) remains at $8,880,000. These assets earn $532,800 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, $532,800 is available for share repurchase. As noted above, 6,660 shares will be repurchased at t = 0. At t = 1, immediately prior to the repurchase, there will be 104,340 shares outstanding. These shares will be worth $8,880,000, or $85.11 per share. With $532,800 available to repurchase shares, the total number of shares repurchased will be 6,260.4. Using this reasoning, we can generate the following table:

Time	Shares Outstanding	Share Price ($8,880,000/No. of Shares O/S)	Shares Repurchased
t = 0	111,000	$80	$532,800/$80=6,660
t = 1	104,340	$85.11	$532,800/$85.11=6,260
t = 2	98,080	$90.54	$532,800/$90.54=5,885
t = 3	92,195	$96.32	$532,800/$96.32=5,532

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 $8,347,200 (the asset value immediately after the dividend) earn $532,800, or a return of 6.38%.