DUKE UNIVERSITY

Fuqua School of Business

FINANCE 351 - CORPORATE FINANCE

Problem Set #8
Prof. Simon Gervais Fall 2011 Term 2

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
sufficient 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 repur-
chase program conveys no information about operating profitability 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 reflect 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, finally, 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 affect 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

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 (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 firm one year hence is $1,545,600. The
appropriate discount rate for Novis is 12%.

(a) What is the current value of the firm?

(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 finance 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 effective 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 defined 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?

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

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 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 flow of dividends.
Therefore it announces that this years dividend will be increased to $2 million (from $1 mil-
lion), 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 firm 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 firm 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 off by this decision (i.e. show
that the present value of the cash flows to the original shareholders remains $20 million).

(Optional) 9. The Government in Dukeraine imposes a flat 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 firm 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 indifferent between buying the stock immediately before or immediately after
it goes ex-dividend? How do you explain the difference between the cum-dividend (with
dividend) and ex-dividend (without dividend) prices?

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 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. (1)

The remaining 100,000 n shares should be worth P each as well, and so

8,000,000
=P (2)
100,000 n

Solving for n and P in (1) and (2), we find n = 4,762 and P = 84.00.
Solution 2: Without the dividend payment, the firm is worth V = $80(100,000) +
$4(100,000) = $8,400,000, which is $8,400,000
100,000 = $84 per share. With $400,000, the firm
$400,000
can therefore repurchase $84 = 4,762 shares.
(c) Old policy:

Year 1 Year 2 Year 3

Total Assets
beginning of year 8.0M 8.0M 8.0M
end of year 8.4M 8.4M 8.4M
Dividends (= Earnings) 0.4M 0.4M 0.4M
Number of shares 100,000 100,000 100,000
Price per share (ex-dividend) 80 80 80

New policy:

Year 1 Year 2 Year 3

Total Assets
beginning of year 8.0M 8.0M 8.0M
end of year 8.4M 8.4M 8.4M
Earnings 0.4M 0.4M 0.4M
Beginning of year
number of shares 100,000 95,238 90,703
price per share 80 84.00 88.20
Number of shares repurchased 4,762 4,535 4,319
End of year
number of shares 95,238 90,703 86,384
price per share (ex-dividend) 84.00 88.20 92.61

2. (a) On the ex-dividend date.

(b) The stock price will fall by $1.

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 (c) The stock price will fall by the after-tax dividend, i.e., by $1(10.3) = $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 profit should be essentially
zero since youve held the stock for a small amount of time (a second, say). Here are
your cash flows:
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 flows should be zero:

10 + 1 0.30 + S = 0 S = 9.30.

The stock price fell by $10.00 $9.30 = $0.70.

(d) In this case, there should be no tax effects, 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 profit 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 profit is

10 + (1 0.30) + S 0.30(S 10) = 0.

Solving for S, we find 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.

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4. (a) Here are the net expected returns on each stock for each of the four investors:

Investor Stock A Stock B Stock C

(i) Pension fund 10 10 10
5[1 (0.3)(0.35)]
10(1 0.35) 10[1 (0.3)(0.35)]
(ii) Corporation +5(1 0.35)
= 6.5 = 8.95
= 7.725
5(1 0.396)
10(1 0.28) 10(1 0.396)
(iii) Individual +5(1 0.28)
= 7.2 = 6.04
= 6.62
10(1 0.35) 10(1 0.35) 10(1 0.35)
(iv) Security dealer
= 6.5 = 6.5 = 6.5

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

(b) Before the dividend is paid, each share is worth

1,412,000
P0 = = 141.20.
10,000
After the dividend is paid, the shares will be worth

1,545,600/1.12 1,412,000 32,000

P00 = = = 138.00.
10,000 10,000

Notice that the difference between P0 and P00 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 firm through the stock price (capital gains). These directors merely want to

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 change the timing of the dividends (more now, less in the future). As shown below,
the current shareholders wealth is unaffected by this dividend increase, i.e., the
shareholders are not made better off.
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 firm 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
1,545,600 11,760
W0 = 42,500 + = 1,412,000,
1.12
the same as before.
(ii) Let n denote the number of new shares that have to be issued, and P00 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
nP00 = 10,500. (3)
Also, after the dividend is paid, the shareholders (both old and new) will be sharing
the future value of the firm, that is

1,545,600/1.12
P00 = . (4)
10,000 + n

Solving (3) and (4) for n and P00 yields n = 76.67 and P00 = 136.95.
Solution 2: After the dividend is paid and the money is raised from the new equity
issue, the firm 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 firm, 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,
1,369,500
P00 = = 136.95 per share.
10,000
The number of new shares that must be issued is therefore
10,500
n= = 76.67.
136.95

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6. The following table shows the after-tax return calculations for the three companies.

Paynone Payless Payall

Next years stock price 125.00 112.50 100.00
Dividend 0.00 12.50 25.00
Total pre-tax payoff 125.00 125.00 125.00
Todays stock price 100.00 Pless Pall
Capital gains 25.00 112.50 Pless 100.00 Pall
Tax on dividend (@25%) 0.00 3.13 6.25
Tax on capital gains (@0%) 0.00 0.00 0.00
Total after-tax income 25.00 12.50 3.13 25.00 6.25
+(112.50 Pless ) +(100.00 Pall )
After-tax rate of return 25% 25% 25%

Since we would like the three after-tax expected returns to be the same, we must have

12.50 3.13 + (112.50 Pless )

25% = , and
Pless
25.00 6.25 + (100.00 Pall )
25% = .
Pall
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 ad-
justment 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.,

1,000,000 1,000,000(1.05) 1,000,000(1.05)2 1,000,000

20,000,000 = + 2
+ 3
+ = .
1+r (1 + r) (1 + r) r 0.05

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

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(b) At the end of the year, the value of the firm will be

1.05 (1.05)2
 
V1 = 1,000,000 + +
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 first year. Since the total number of shares
after the new issue will be 1,000,000 + n, we have
V1 21,000,000
P1 = = . (5)
1,000,000 + n 1,000,000 + n

It also has to be the case that the extra dividend of $1 million paid at the end of the
first year is financed 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

1,000,000
n= = 50,000 shares.
20

(d) The new shareholders will be getting a fraction

50,000 1
=
1,000,000 + 50,000 21
1 20
of future dividends, whereas the original shareholders will be getting a fraction 1 21 = 21
of these dividends.
(e) The present value of the cash flows to the original shareholders is

(1.05)2 (1.05)3
  
2 20 1.05
P V = 1,000,000 + + + +
1.1 21 (1.1)2 (1.1)3 (1.1)4
  
2 20 1.05 1
= 1,000,000 +
1.1 21 0.1 0.05 1.1
= 20,000,000.

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9. Let Sed denote the ex-dividend stock price. We then have the following cash flows associated
with buying cum-dividend or ex-dividend:

Cash Flow Today Cash Flow in 1 Year

Buy cum-dividend 100 + 1 S1 0.20(S1 100) 0.30(1)
Buy ex-dividend Sed S1 0.20(S1 Sed )
Difference in CFs 99 + Sed 19.7 0.20Sed

Investors would be indifferent between buying cum-dividend or ex-dividend if and only if the
present value of the differential cash flow is zero, i.e., if
19.7 0.20Sed
99 + Sed + = 0.
1.10
Solving, gives Sed = 99.111. Therefore, after the dividend payment, the stock price drops by
less than $1. This reflects the fact that capital gains are taxed at a lower rate than dividends.

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