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 incash. 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. According to Modigliani and miller model, the dividends are irrelevant. Hence they proposed a dividend irrelevance theory. Hence there should be no effect on the stock price because of the announcement of the special dividend.

b. The stock price on the ex-dividend date= $20-1 = $19. The stock price is reduced by the amount of dividend paid

c. Similar to the dividend theory, the Modigliani and miller model proposes that the investors indifferent towards the repurchase. Hence the repurchase will have no effect on the share price

d. Since the dividends are tax at personal tax rate, it makes better sense to go for share repurchase.

When the dividends are announced, the stock price tends to move up as several people purchase the stock just to get the dividend and sell it afterwards. So the stock price moves up on the announcement date and on the ex-dividend date, the price is reduced by the extent of dividend declared.

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