FINANCIAL THEORY AND CORPORATE POLICY:

SUGGESTED ANSWERS - SEMINAR 8

QUESTION 1

Suppose an investor is seeking a profitable opportunity by trading over the ex-dividend date.

a) State the no-arbitrage condition of trading over the ex-dividend date.

b) Explain what would happen if the condition does not hold

c) Explain the dividend-capture theory.

Answers:

a) (Pcum- Pex)(1-τg)= D(1-τd)

b)

If (Pcum- Pex)(1-τg)> D(1-τd) nobody will want to buy the security at P cum as the dividend provided will not be
sufficient. Hence the current price Pcum will fall until the zero arbitrage condition holds

If (Pcum- Pex) (1-τg) < D(1-τd), everybody will want to buy the security at P cum thefore Pcum will go up until the
zero arbitrage condition holds

c) Each investor group is faced with different tax rates that make their preferences over dividend income and
capital gains differ. Thus, when the dividend is announced, tax-free investors buy stocks to receive dividends
and individual investors sell them to avoid dividends just after the dividend announcement. After dividends are
paid, the trades are reversed. It explains the pattern of trading volume around the ex-dividend date.

QUESTION 2

You are considering two investments of similar risk. Investment A is a stock that is expected to pay a dividend
of $100 at the end of each year for two years, but no dividend in the third year. You expect to sell Investment A
after three years for a capital gain of $400. Investment B is a stock that is not expected to pay any dividends, but
you expect to sell the stock at the end of three years for a capital gain of $600. You are wealthy and in the 50%
tax bracket. Dividends are taxed at the personal tax rate, but capital gains are taxed at 40% of the personal tax
rate. Given a discount rate of 10% for both investments, which do you prefer?

Answer:

You can creat the following table of cash flows for both investments :

Period
Adjusted for tax and time
Firm A Cash flow value of money
1 100 100*(1-0.5)/1.1 45.45454545
2 100 100*(1-0.5)/1.1^2 41.32231405
3 400 400*(1-0.4*0.5)/1.1^3 240.4207363
1
 Total PV 327.1975958

Firm B
1 0
2 0
3 600 600*(1-0.4*0.5)/1.1^3 360.6311044
Total PV 360.6311044

Given that the after tax Present Value of the cash flows in B is greater that in A we choose B.

QUESTION 3

GHR Corp. is deciding how much it should pay out to its stockholders. It has $150 million in cash available for
investment. The following information is provided on the firm:

(a) It has 100 million shares outstanding. Each share sells for $5. The beta of the stock is 1.4, and the treasury
bond rate is 7% and the market return is 12.5%

(b) The tax rate for the average stockholder on ordinary income is 40% and 20% on capital gains.

(c) The firm has $200 million (market value and book value) of debt outstanding. The marginal interest rate on
the debt is 10%.

(d) The corporation's tax rate is 40%.

(e) The firm has the following 5 investment projects available:

How much cash, if any, should be returned to stockholders?

(ii) If the cash is paid as a dividend to shareholders, what will the per share price be after the exdividend date?
(Assume that $5 is the price before the ex-dividend date)

Answers:

Re = 7% + 1.4(5.5%) = 14.7%

WACC = 500/700*14.7% + 200/700*10%(1-.4) = 12.21%

Accept projects A,B,C costing $60 . Pay $90 dividend

Div/share = 90/100 = .9/share

(Pcum - Pex)(1-τg)= d(1-τd)

Pcum = 5
2
τg = 20%

D=0.9

τd = 40%

Pex = 4.325

QUESTION 4

The balance sheet of XYZ company is given as follows:

Cash 2000 Debt 5,000

Inventory 2,000 Equity 5,000

P, P & E 6,000

Total Assets 10,000 Total liabilities 10,000

The company has decided to pay 2000 cash to shareholders. There are four ways to do it:

(i) Use the cash to pay dividends

(ii) Issue 1000 each of new debt and new equity and use the proceeds to pay a dividend
(iii) Issue 2000 in new equity and use the proceeds to pay a dividend
(iv) Use the cash to repurchase shares

What will be the impact of each of the four policies above on the following:

a) systematic risk of the portfolio of assets held by the company

b) the market value of the original bondholder’s wealth
c) the book value of the debt to equity ratio
d) the market value of the firm in a world without taxes

Answers:

(i) If the firm decides to pay a cash dividend

(a) The systematic risk of its portfolio of assets will increase because a low risk asset (i.e., the $2,000 of
cash) will be “spun off” to shareholders.

(b) The market value of bondholders’ wealth will decline relative to the market value of equity because the
debt-holders expect to have claim on fewer and riskier assets.

(c) The debt to equity ratio will increase on the ex-dividend date. The ex-dividend balance sheet is shown
below.

Cash 0 Debt 5,000

Inventory 2,000 Equity 3,000

P, P & E 6,000 Total liabilities 8,000

Total Assets 8,000

3
 D 5000
Predividend = =1
E 5000

D 5000
Ex−dividend = =1.667
E 3000

(d) Prior to the ex-dividend date the market value of the firm will be unchanged in a world without taxes.
After the ex-dividend date it will fall by $2,000, the amount of the dividend payment.

(ii) If the firm decides to issue $1,000 of new debt and an equal amount of new equity in order to finance
the dividend payment, the ex-dividend balance sheet will look like that below.

Cash 2,000 Debt 6,000

Inventory 2,000 Equity 4,000

P, P & E 6,000 Total 10,000

liabilities

Total assets 10,000

In anticipation of these changes the various impacts will be:

(a) The systematic risk of the portfolio of assets will remain unchanged since the cash payment is raised
from external funds, thereby leaving the assets side of the balance sheet unchanged.

(b) If new debt is not subordinate to old debt, then the market value of the outstanding bonds will decline
because their claim on the assets of the firm must be shared with new bondholders.

(c) The debt-equity ratio will obviously increase:

D 6000
Ex−dividend = =1.5
E 4000

(d) Prior to the ex-dividend date the market value of the firm will increase by $2,000, the value of the new
debt and equity. However, when the $2,000 is paid out the value of the firm returns to its original level.

(iii) If the firm issues $2,000 in new equity, then pays out an equal amount in dividends, the ex-dividend
balance sheet will be exactly the same as the pre-dividend balance sheet. There will be no changes in

(a) the systematic risk of the firm’s portfolio of assets,

(b) the wealth of original bondholders,

(c) the debt to equity ratio, or

(d) the market value of the firm.

(iv) Using cash to repurchase equity has the same effects (in a world without taxes) as paying a cash
dividend to shareholders. Therefore, the same answer used in i) applies here.