1.Whole Foods Donuts , Ltd has generated profits of $2 per share for many years

Question

1.Whole Foods Donuts , Ltd has generated profits of $2 per share for many years and has consistently paid 100% of those profits to shareholders via a dividend . Investors do not expect Hole Foods Donuts to grow in the future . The company has 200,000 shares of stock outstanding worth $20 per share. Suppose the firm decides to eliminate its dividend and instead use the money to repurchase shares.

Required:

(a)Assuming that there are no taxes and that the repurchase announcement conveys no new information to investors about the profitability or risk of Hole Foods Donuts , how do you think the stock price will react to the announcement ? Provide a written (in words) explanation or a numerical example to provide supports for your answer .

(b)How many shares will Hole Foods Donuts repurchase?

(c)If the signaling argument for repurchases is valid , what stock price would you expect for Hole Foods Donuts one and two years after this announcement ? What would the stock price have been in the next two years if the company had simply maintained its old dividend policy?  

Explanation / Answer

a) The stock will react positively to the announcement because repurchase of the stock indicates confidence by the management in their company stock. Many companies initiate a share repurchase at a price level that management deems a good entry point. This point tends to be when the stock is estimated to be undervalued. If a company knows its business and relative stock price well, would it purchase its stock price at a high level? The answer is no, leading investors to believe that management perceives its stock price to be at a low level.

b) No of shares: 200,000

profits = 2 per share that equates to =200,000*2=4,00,000 is the cash available

400,000=n*20

n= 20,000

It can buy 20,000 shares from the dividend money left

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