An unlevered firm has a market value of $10 million, with $1 million of its asse

Question

An unlevered firm has a market value of $10 million, with $1 million of its assets in cash. With 500,000 shares outstanding, its current stock price is $20.

a) Under the assumptions of Modigliani-Miller, what is the effect on the stock price of an announcement of a $1 special dividend to be paid in 6 months?

b) Find the new stock price after the ex-dividend date.

c) Assume that firm decides to repurchase $500,000 worth of stock instead. Under the assumptions of Modigliani-Miller, what happens to the share price after the repurchase takes place?

d) Assume now that the personal tax rate exceeds the capital gains tax rate. Will investors prefer the dividend or share repurchase? What happens to the stock price at announcement if the firm decides to pay a special dividend?

Explanation / Answer

a) on announcement of $ 1 as dividend will effect the price of the stock to move to $ 21 i.e stock price + value of he dividend. $ 20+$ 1=$ 21

b) after the ex-dividend date stock price will come down to $ 20 i.e privious days closing price - (minus) the upcomming dividend per share.

c) repurchased shares are $ 500000/$ 20= 25000

remaing shares = $ 10000000/ $ 20=500000-25000=475000

new price of the stock = $ 10000000/475000=$ 21.05

d) when tax rate exceeds the capital gain tax rate investors would not prefer dividend,insted prefers share repurchase. the stock price will move upward .

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