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Class 12 - Payout Policy - 1

1. A company repurchased 200,000 shares at $200 each, reducing shares outstanding to 800,000 and increasing earnings per share to $12.50. Assuming the price-earnings ratio stays at 20, the share price must rise to $250. 2. A stock trading at $65 before paying a $10 dividend fell to $57 after paying the dividend. This implies a personal tax rate on dividends of 40%. 3. A company with 1 million shares valued at $20 million plans to increase its $1 million annual dividend to $2 million by issuing new shares. The value to current shareholders remains $20 million even though new shares are issued.

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159 views1 page

Class 12 - Payout Policy - 1

1. A company repurchased 200,000 shares at $200 each, reducing shares outstanding to 800,000 and increasing earnings per share to $12.50. Assuming the price-earnings ratio stays at 20, the share price must rise to $250. 2. A stock trading at $65 before paying a $10 dividend fell to $57 after paying the dividend. This implies a personal tax rate on dividends of 40%. 3. A company with 1 million shares valued at $20 million plans to increase its $1 million annual dividend to $2 million by issuing new shares. The value to current shareholders remains $20 million even though new shares are issued.

Uploaded by

Stepan Maykov
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Class 12 - Payout policy -1

Problem 1
“Many companies use stock repurchases to increase earnings per share. For example,
suppose that a company is in the following position:
Net profit $ 10 mln
Number of shares before repurchase 1 mln
Earnings per share $10
Price earnings ratio 20
Share price $200

The company now repurchases 200000 shares at $200. The number of shares declines to
800000 and the earnings per share increase to $12.50. Assuming the price-earnings ratio
stays at 20, the share price must rise to $250.” Discuss this situation.

Problem 2
PowGreen is priced at $65.00 before dividend. The ex-dividend price decreases to $57
when a dividend of $10.00 is paid. Determine the implied personal tax rate on dividends.
Assume that the tax on capital gains is 40%.

Problem 3
Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is
expected to pay $1 million of dividends next year, and thereafter the amount paid out is
expected to grow by 5 percent a year in perpetuity. However, the company has heard
that the value of a share depends on the flow of dividends, and therefore it announces
that next year’s dividend will be increased to $2 million and that the extra cash will be
raised immediately by an issue of shares. After that, the total amount paid out each year
will be as previously forecasted, that is, $1.05 million in year 2 and increasing by 5 percent
in each subsequent year.
a. At what price will the new shares be issued in year 1?
b. How many shares will the firm need to issue?
c. What will be the expected dividend payments on these new shares, and what
therefore will be paid out to the old shareholders after year 1?
d. Show that the present value of the cash flows to current shareholders remains $20
million.
e. Assume that new shares are issued in year 1 at $10 a share. Show who gains and who
loses. Is dividend policy still irrelevant? Why or why not?

Problem 4
Consider the following two statements: “Dividend policy is irrelevant,” and “Stock price is
the present value of expected future dividends.” They sound contradictory. This question
is designed to show that they are fully consistent. The current price of the shares of
Charles River Mining Corporation is $50. Next year’s earnings and dividends per share are
$4 and $2, respectively. Investors expect perpetual growth at 8 percent per year. The
expected rate of return demanded by investors is r=12 percent. Suppose that Charles
River Mining announces that it will switch to a 100 percent payout policy, issuing shares as
necessary to finance growth. Use the perpetual-growth model to show that current stock
price is unchanged.

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