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Chapter 17
Payout Policy
17-3.
Describe the different mechanisms available to a firm to use to repurchase shares
There are three mechanisms. 1) In an open-market repurchase, the firm repurchases the shares in the
open market. This is the most common mechanism in the United States. 2) In a tender offer the firm
announces the intention to all shareholders to repurchase a fixed number of shares for a fixed price,
conditional on shareholders agreeing to tender their shares. If not enough shares are tendered, the deal
can be cancelled. 3) A targeted repurchase is similar to a tender offer except it is not open to all
shareholders; only specific shareholder can tender their shares in a targeted repurchase.
17-4.
RFC Corp. has announced a $1 dividend. If RFC’s price last price cum-dividend is $50, what
should its first ex-dividend price be (assuming perfect capital markets)?
Assuming perfect markets, the first ex-dividend price should drop by exactly the dividend payment.
Thus, the first ex-dividend price should be $49 per share. In a perfect capital market, the first price of
the stock on the ex-dividend day should be the closing price on the previous day less the amount of the
dividend.
17-5.
17-6.
EJH Company has a market capitalization of $1 billion and 20 million shares outstanding. It
plans to distribute $100 million through an open market repurchase. Assuming perfect capital
markets:
a.
What will the price per share of EJH be right before the repurchase?
b.
How many shares will be repurchased?
c.
What will the price per share of EJH be right after the repurchase?
a.
$1 billion/20 million shares = $50 per share.
b.
$100 million/$50 per share = 2 million shares.
c.
If markets are perfect, then the price right after the repurchase should be the same as the price
immediately before the repurchase. Thus, the price will be $50 per share.
KMS Corporation has assets with a market value of $500 million, $50 million of which are cash.
It has debt of $200 million, and 10 million shares outstanding. Assume perfect capital markets.
a.
What is its current stock price?
b.
If KMS distributes $50 million as a dividend, what will its share price be after the dividend
is paid?
c.
If instead, KMS distributes $50 million as a share repurchase, what will its share price be
once the shares are repurchased?
d.
What will its new market debt-equity ratio be after either transaction?
a.
(500 – 200)/10 = 30
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17-7.
17-11.
17-15.
b.
(450 – 200)/10 = 25
c.
(450 – 200)/(10 – 1.667) = 30
d.
200/250 = 0.8
Natsam Corporation has $250 million of excess cash. The firm has no debt and 500 million
shares outstanding, with a current market price of $15 per share. Natsam’s board has decided to
pay out this cash as a one-time dividend.
a.
What is the ex-dividend price of a share in a perfect capital market?
b.
If the board instead decided to use the cash to do a one-time share repurchase, in a perfect
capital market what is the price of the shares once the repurchase is complete?
c.
In a perfect capital market, which policy, in part (a) or (b), makes investors in the firm
better off?
a.
The dividend payoff is $250/$500 = $0.50 on a per share basis. In a perfect capital market the
price of the shares will drop by this amount to $14.50.
b.
$15
c.
Both are the same.
The HNH Corporation will pay a constant dividend of $2 per share, per year, in perpetuity.
Assume all investors pay a 20% tax on dividends and that there is no capital gains tax. Suppose
that other investments with equivalent risk to HNH stock offer an after-tax return of 12%.
a.
What is the price of a share of HNH stock?
b.
Assume that management makes a surprise announcement that HNH will no longer pay
dividends but will use the cash to repurchase stock instead. What is the price of a share of
HNH stock now?
a.
P = $1.60/0.12 = $13.33
b.
P = $2/0.12 = $16.67
Suppose that all capital gains are taxed at a 25% rate, and that the dividend tax rate is 50%.
Arbuckle Corp. is currently trading for $30, and is about to pay a $6 special dividend.
a.
Absent any other trading frictions or news, what will its share price be just after the
dividend is paid?
Suppose Arbuckle made a surprise announcement that it would do a share repurchase rather
than pay a special dividend.
17-18.
b.
What net tax savings per share for an investor would result from this decision?
c.
What would happen to Arbuckle’s stock price upon the announcement of this change?
a.
t*_ d = (50% – 25%)/(1 – 25%) = 33.3%, P_ex = 30 – 6(1 – t*) = $26
b.
With dividend, tax would be 6  50% = $3 for dividend, with a tax savings of 4  25% = $1 for
capital loss, for a net tax from the dividend of $2 per share. This amount would be saved if
Arbuckle does a share repurchase instead.
c.
Stock price rises to by $2 to $32 to reflect the tax savings.
At current tax rates, which of the following investors are most likely to hold a stock that has a
high dividend yield:
a.
Individual investors?
b.
Pension funds?
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Chapter 17/Payout Policy
17-19.
c.
Mutual funds?
d.
Corporations?
d.
Corporations
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Que Corporation pays a regular dividend of $1 per share. Typically, the stock price drops by
$0.80 per share when the stock goes ex-dividend. Suppose the capital gains tax rate is 20%, but
investors pay different tax rates on dividends. Absent transactions costs, what is the highest
dividend tax rate of an investor who could gain from trading to capture the dividend?
Because the stock price drops by 80% of the dividend amount, shareholders are indifferent if t*_d =
20%. From Eq. 17.3, (td – tg)/(1 – tg) = t*, so td = tg + t* (1 – tg) = 36%. Investors who pay a lower
tax rate than 36% could gain from a dividend capture strategy.
17-21.
17-26.
17-29.
Clovix Corporation has $50 million in cash, 10 million shares outstanding, and a current share
price of $30. Clovix is deciding whether to use the $50 million to pay an immediate special
dividend of $5 per share, or to retain and invest it at the risk-free rate of 10% and use the $5
million in interest earned to increase its regular annual dividend of $0.50 per share. Assume
perfect capital markets.
a.
Suppose Clovix pays the special dividend. How can a shareholder who would prefer an
increase in the regular dividend create it on her own?
b.
Suppose Clovix increases its regular dividend. How can a shareholder who would prefer the
special dividend create it on her own?
a.
Invest the $5 special dividend, and earn interest of $0.50 per year.
b.
Borrow $5 today, and use the increase in the regular dividend to pay the interest of $0.50 per year
on the loan.
Raviv Industries has $100 million in cash that it can use for a share repurchase. Suppose instead
Raviv invests the funds in an account paying 10% interest for one year.
a.
If the corporate tax rate is 40%, how much additional cash will Raviv have at the end of the
year net of corporate taxes?
b.
If investors pay a 20% tax rate on capital gains, by how much will the value of their shares
have increased, net of capital gains taxes?
c.
If investors pay a 30% tax rate on interest income, how much would they have had if they
invested the $100 million on their own?
d.
Suppose Raviv retained the cash so that it would not need to raise new funds from outside
investors for an expansion it has planned for next year. If it did raise new funds, it would
have to pay issuance fees. How much does Raviv need to save in issuance fees to make
retaining the cash beneficial for its investors? (Assume fees can be expensed for corporate
tax purposes.)
a.
100  10%  (1 – 40%) = $6 m
b.
$6  (1 – 0.20) = $4.8 million
c.
100  10%  (1 – 0.30) = $7 million
d.
$1 spent on fees = $1  (1 – 0.40)  (1 – 0.20) = $0.48 to investors after corporate and cap gain
tax. To make up the shortfall, fees = (7 – 4.8)/0.48 = $4.583 million.
Why is an announcement of a share repurchase considered a positive signal?
By choosing to do a share repurchase, management credibly signals that they believe the stock is
undervalued.
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