DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #8 Prof.

Simon Gervais Questions 1. Hors dAge Cheeseworks has been paying a regular cash dividend of $4 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 100,000 shares outstanding selling for $80 per share. The company has sucient cash on hand to pay the next annual dividend. Suppose that Hors dAge 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 protability or business risk. (b) How many shares will Hors dAge purchase? (c) Project and compare future stock prices for the old and new policies. Do this for at least years 1, 2, and 3. 2. Formaggio Vecchio has just announced its regular quarterly cash dividend of $1 per share. (a) When will the stock price fall to reect dividend paymenton the record date, the ex-dividend date, or the payment date? (b) Assume that there are no taxes. By how much is the stock price likely to fall? (c) Now assume that all investors pay tax of 30% on dividends and nothing on capital gains. What is the likely fall in the stock price? (d) Suppose, nally, that everything is the same as in part (c), except that security dealers pay tax on both dividends and capital gains. How would you expect your answer to (c) to change? Explain. 3. Refer back to the last question. Assume no taxes and a stock price immediately after the dividend announcement of $100. (a) If you own 100 shares, what is the value or your investment? How does the dividend payment aect your wealth? (b) Now suppose that Formaggio Vecchio cancels the dividend payment and announces that it will repurchase 1% of its stock at $100. Do you rejoice or yawn? Explain. 4. The expected pretax return on three stocks is divided between dividends and capital gains in the following way: Expected Expected Stock Dividend Capital Gain A $0 $10 B $5 $5 C $10 $0 1 Fall 2011 Term 2

(a) If each stock is priced at $100, what are the expected net returns on each stock to (i) a (tax-exempt) pension fund; (ii) a corporation paying tax at 35% (recall that corporations are taxed on only 30% of the dividends that they receive; they are fully taxed on the capital gains); (iii) an individual paying tax at 39.6% on investment income and 28% on capital gains; (iv) a security dealer paying tax at 35% on investment income and capital gains? (b) Suppose that before the 1986 Tax Reform Act stocks A, B and C were priced to yield an 8% after-tax return to individual investors paying 50% tax on dividends and 20% tax on capital gains. What would A, B and C each sell for? 5. The net income of Novis Corporation, which has 10,000 outstanding shares and a 100% payout policy, is $32,000 today. The expected value of the rm one year hence is $1,545,600. The appropriate discount rate for Novis is 12%. (a) What is the current value of the rm? (b) What is the ex-dividend price of Novis stock if the board follows its current dividend policy? (c) At the dividend declaration meeting, several board members claimed that the dividend is too meager and is probably depressing Novis stock price. They propose that Novis sell enough new shares to nance a $4.25 dividend. Assume that the new shareholders are not entitled to this dividend (i.e., assume that their shares are issued ex-dividend). (i) Comment on the claim that the low dividend is depressing the stock price. Support your argument with calculations. (ii) If the proposal is adopted, at what price will the new shares sell and how many will be sold? 6. Payall Inc., Payless Inc., and Paynone Inc. have identical operations. They follow a large, medium, and zero (no dividend) payout policy respectively. Paynone Inc.s shares currently trade at $100, and are expected to trade at $125 in one year. The expected dividends per share (in one year) for Payall and Payless are $25 and $12.50 respectively, and their ex-dividend stock prices are expected to be $100 and $112.50 respectively. The market prices are set so that their after-tax expected returns are equal. What should the current share prices of Payless Inc. and Payall Inc. be? Assume that the marginal personal tax rate on dividends is 25%, and the eective tax rate on capital gains is zero. 7. The Sharpe Co. has a period 0 dividend of $1.25. Its target payout ratio is 40%. The period 1 EPS is expected to be $4.5. (a) If the adjustment rate is 0.3 as dened in the Lintner model, what will be the Sharpe Co. dividend in period 1? (b) If the adjustment rate is 0.6 instead, what is the dividend in period 1?
(Dicult)

8. The Nilpoj corporation has 1 million shares outstanding with a total market value of $20 million. Nilpoj is expected to pay $1 million of dividends at the end of the year (i.e. one year from

now), and thereafter the amount paid out is expected to grow by 5% a year in perpetuity. Thus the expected dividend at the end of the second year is $1.05 million, and so on. However, the company has heard that the value of a share depends on the ow of dividends. Therefore it announces that this years dividend will be increased to $2 million (from $1 million), and that the extra cash will be raised at the end of the year by an issue of shares. After that, the total amount paid out in dividends each year will be as previously forecast, i.e. $1.05 million at the end of year 2 and increasing at 5% a year in each subsequent year. (a) What is Nilpojs cost of capital. (b) What will the total value of the rm be at the end of the year (after the extra cash is raised and after the $2 million dividend is paid out)? (c) How many shares will the rm need to issue, and what is the price per share at the end of the year (after the extra cash is raised and after the $2 million dividend is paid out)? (d) What fraction of future dividends (starting with the second-year dividends) belongs to the original shareholders? (e) Show that the original shareholders are not made better o by this decision (i.e. show that the present value of the cash ows to the original shareholders remains $20 million).
(Optional)

9. The Government in Dukeraine imposes a at tax rate of 20% on realized capital gains and losses. The tax rate on personal income is 30%. The corporate tax rate is 35%. The stock of a rm in Dukeraine is currently priced at $100 per share, and is about to go ex-dividend, paying $1 as dividend to holders of record. Assume that the (after-tax) interest rate is 10%, that the dividend is paid immediately and that all taxes are paid one year from now. What should be the ex-dividend price for an investor who is planning to hold the stock for one year to be indierent between buying the stock immediately before or immediately after it goes ex-dividend? How do you explain the dierence between the cum-dividend (with dividend) and ex-dividend (without dividend) prices?

Solutions 1. (a) There should be no reaction. (b) Solution 1: The total dividend is $4(100,000) = $400,000. If Hors dAge repurchases n shares at a price of P each, then we need nP = 400,000. The remaining 100,000 n shares should be worth P each as well, and so 8,000,000 =P 100,000 n (2) (1)

Solving for n and P in (1) and (2), we nd n = 4,762 and P = 84.00. Solution 2: Without the dividend payment, the rm is worth V = $80(100,000) + ,400,000 $4(100,000) = $8,400,000, which is $8 100,000 = $84 per share. With $400,000, the rm can therefore repurchase (c) Old policy: Year 1 Total Assets beginning of year end of year Dividends (= Earnings) Number of shares Price per share (ex-dividend) New policy: Year 1 Total Assets beginning of year end of year Earnings Beginning of year number of shares price per share Number of shares repurchased End of year number of shares price per share (ex-dividend) 2. (a) On the ex-dividend date. (b) The stock price will fall by $1. 8.0M 8.4M 0.4M 100,000 80 4,762 95,238 84.00 Year 2 8.0M 8.4M 0.4M 95,238 84.00 4,535 90,703 88.20 Year 3 8.0M 8.4M 0.4M 90,703 88.20 4,319 86,384 92.61 8.0M 8.4M 0.4M 100,000 80 Year 2 8.0M 8.4M 0.4M 100,000 80 Year 3 8.0M 8.4M 0.4M 100,000 80
$400,000 $84

= 4,762 shares.

(c) The stock price will fall by the after-tax dividend, i.e., by $1(1 0.3) = $0.70, so that the after-tax return on dividends and capital gains are the same. To see this more clearly, suppose the stock price is 10 before the dividend is paid. If you buy the stock right before the dividend is paid and sell it right after, your net prot should be essentially zero since youve held the stock for a small amount of time (a second, say). Here are your cash ows: buy now: -10.00; dividend: +1.00; tax on dividend: -0.30; sell after dividend: S (to be found).

So the sum of all these cash ows should be zero: 10 + 1 0.30 + S = 0 The stock price fell by $10.00 $9.30 = $0.70. (d) In this case, there should be no tax eects, i.e., the stock price will fall by $1. To better see this, suppose you buy the stock (for $10, say) right before the dividend is paid, and sell it right after the dividend is paid. Because you hold the stock for a small amount of time (a second, say), your net prot should be zero. You pay $10 for the stock, you receive $1 as a dividend which is taxed at 30%; then you sell it for S (to be found) and pay taxes of 30% (S 10) on your capital gains (which are going to be negative here). So you net prot is 10 + (1 0.30) + S 0.30(S 10) = 0. Solving for S , we nd S = 9. So the change in S is $10 $9 = $1. 3. (a) After the dividend announcement, the value of your investment is 100 $100 = $10,000. After the dividend payment, the stock price drops to $99, and you will have received a dividend of $1 for each share you own. Hence, your wealth will remain the same: (100 $99) + (100 $1) = $10,000. (b) You yawn. After Formaggio Vecchio repurchases 1% of your shares (i.e., one share) at $100 each, you will be left with 99 shares worth $100 each. Your total wealth after the repurchase will then be: (99 $100) + (1 $100) = $10,000. S = 9.30.

4. (a) Here are the net expected returns on each stock for each of the four investors: Investor (i) Pension fund (ii) Corporation Stock A 10 10(1 0.35) = 6.5 10(1 0.28) = 7.2 10(1 0.35) = 6.5 Stock B 10 5[1 (0.3)(0.35)] +5(1 0.35) = 7.725 5(1 0.396) +5(1 0.28) = 6.62 10(1 0.35) = 6.5 Stock C 10 10[1 (0.3)(0.35)] = 8.95 10(1 0.396) = 6.04 10(1 0.35) = 6.5

(iii) Individual

(iv) Security dealer

(b) The yearly after-tax payo of stock A is 10(1 0.2) = 8, so that the price of stock A should be 8 = 100. PA = 0.08 The yearly after-tax payo of stock B is 5(1 0.5) + 5(1 0.2) = 6.5, so that the price of stock B should be 6.5 = 81.25. PB = 0.08 The yearly after-tax payo of stock C is 10(1 0.5) = 5, so that the price of stock C should be 5 = 62.50. PC = 0.08 5. (a) The value of the rm is the present value of its dividends and future value: V0 = 32,000 + 1,545,600 = 1,412,000. 1.12

(b) Before the dividend is paid, each share is worth P0 = 1,412,000 = 141.20. 10,000

After the dividend is paid, the shares will be worth P0 = 1,545,600/1.12 1,412,000 32,000 = = 138.00. 10,000 10,000

Notice that the dierence between P0 and P0 is the dividend per share, 32,000/10,000 = 3.20. (c) (i) According to Modigliani and Miller, it cannot be true that the low dividend is depressing the price. In fact, since the dividend policy is irrelevant, the level of the dividend should not matter: any funds not distributed as dividends add to the value of the rm through the stock price (capital gains). These directors merely want to 6

change the timing of the dividends (more now, less in the future). As shown below, the current shareholders wealth is unaected by this dividend increase, i.e., the shareholders are not made better o. To pay the $4.25 dividend per share (for a total dividend of $42,500), new shares must be sold. These new shares must have a value of $10,500 ($42,500 $32,000). This means that some of the $1,545,600 rm value in one year will belong to the new shareholders. How much? Well, these new shareholders will also demand a 12% return on their investment, i.e., their $10,500 should then be worth $11,760 ($10,500 1.12). So the current shareholders wealth at time 0 must be W0 = 42,500 + 1,545,600 11,760 = 1,412,000, 1.12

the same as before. (ii) Let n denote the number of new shares that have to be issued, and P0 the price after the $4.25 dividend has been paid. Solution 1: Since the new shareholders will not be fooled and will require their $10,500 investment to be worth exactly that after the dividend is paid, we must have nP0 = 10,500. (3) Also, after the dividend is paid, the shareholders (both old and new) will be sharing the future value of the rm, that is P0 = 1,545,600/1.12 . 10,000 + n (4)

Solving (3) and (4) for n and P0 yields n = 76.67 and P0 = 136.95. Solution 2: After the dividend is paid and the money is raised from the new equity issue, the rm is worth 1,545,600 V = = 1,380,000. 1.12 For the new shareholders to be willing to pay $10,500 for their share in the rm, it must be that their claim is worth $10,500. This implies that 1,380,000 10,500 = 1,369,500 belongs to the old shareholders, that is, P0 = 1,369,500 = 136.95 per share. 10,000

The number of new shares that must be issued is therefore n= 10,500 = 76.67. 136.95

6. The following table shows the after-tax return calculations for the three companies. Paynone 125.00 0.00 125.00 100.00 25.00 0.00 0.00 25.00 25% Payless 112.50 12.50 125.00 Pless 112.50 Pless 3.13 0.00 12.50 3.13 +(112.50 Pless ) 25% Payall 100.00 25.00 125.00 Pall 100.00 Pall 6.25 0.00 25.00 6.25 +(100.00 Pall ) 25%

Next years stock price Dividend Total pre-tax payo Todays stock price Capital gains Tax on dividend (@25%) Tax on capital gains (@0%) Total after-tax income After-tax rate of return

Since we would like the three after-tax expected returns to be the same, we must have 25% = 25% = 12.50 3.13 + (112.50 Pless ) , Pless 25.00 6.25 + (100.00 Pall ) . Pall and

These imply Pless = 97.50 and Pall = 95.00. 7. We know that the Lintner dividend model is given by D1 = a(p E1 ) + (1 a)D0 , where, in this case, p = 0.4, E1 = 4.50, and D0 = 1.25. (a) If a = 0.3, we have D1 = 0.3(0.4 4.50) + (1 0.3)1.25 = 1.415. (b) If a = 0.6, we have D1 = 0.6(0.4 4.50) + (1 0.6)1.25 = 1.58. Notice that the increase in the dividend is more conservative in part (a) since the adjustment rate is lower (i.e., more weight is put on last years dividend). 8. (a) We know that the current value of Nilpoj is $20 million, and that this number represents the present value of discounted dividends, i.e., 20,000,000 = 1,000,000 1,000,000(1.05) 1,000,000(1.05)2 1,000,000 + + + = . 2 3 1+r (1 + r ) (1 + r ) r 0.05

This implies that the cost of capital for Nilpoj is r = 10%.

(b) At the end of the year, the value of the rm will be V1 = 1,000,000 1.05 (1.05)2 + + 1.1 (1.1)2 1.05 = 1,000,000 0.1 0.05 = 21,000,000.

(c) Let n denote the number of new shares that will need to be issued, and P1 the price of each share (old and new) at the end of the rst year. Since the total number of shares after the new issue will be 1,000,000 + n, we have P1 = 21,000,000 V1 = . 1,000,000 + n 1,000,000 + n (5)

It also has to be the case that the extra dividend of $1 million paid at the end of the rst year is nanced by the new issue of shares (i.e., the new investors get what they pay for): nP1 = 1,000,000. (6) Using this last equation in (5) yields: (1,000,000 + n)P1 = 21,000,000
(6)

1,000,000P1 + 1,000,000 = 21,000,000 P1 = 20.

We can now use this value in (6) to obtain n= 1,000,000 = 50,000 shares. 20

(d) The new shareholders will be getting a fraction 50,000 1 = 1,000,000 + 50,000 21
1 = of future dividends, whereas the original shareholders will be getting a fraction 1 21 of these dividends. 20 21

(e) The present value of the cash ows to the original shareholders is PV = 1,000,000 = 1,000,000 = 20,000,000. 2 20 1.05 (1.05)2 (1.05)3 + + + + 1.1 21 (1.1)2 (1.1)3 (1.1)4 2 1 20 1.05 + 1.1 21 0.1 0.05 1.1

9. Let Sed denote the ex-dividend stock price. We then have the following cash ows associated with buying cum-dividend or ex-dividend: Cash Flow Today Buy cum-dividend Buy ex-dividend Dierence in CFs 100 + 1 Sed 99 + Sed Cash Flow in 1 Year S1 0.20(S1 100) 0.30(1) S1 0.20(S1 Sed ) 19.7 0.20Sed

Investors would be indierent between buying cum-dividend or ex-dividend if and only if the present value of the dierential cash ow is zero, i.e., if 99 + Sed + 19.7 0.20Sed = 0. 1.10

Solving, gives Sed = 99.111. Therefore, after the dividend payment, the stock price drops by less than $1. This reects the fact that capital gains are taxed at a lower rate than dividends.

10