Bopomo Corporation\'s has $20 million in excess cash. The firm expects to genera
ID: 2802002 • Letter: B
Question
Bopomo Corporation's has $20 million in excess cash. The firm expects to generate future free cash flows of $48 million per year. The firm is 100% equity financed, and its equity cost of capital is 12%. The firm has 10 million shares outstanding. 2.1 The firm is evaluating two options on how to pay out to shareholders this year: 1) paying dividend of $2 per share using the existing $20 million cash, and 2) paying a dividend of $4 per share, and raising additional $28 million cash by selling new shares. ...continued overleaf Consider a perfect capital market where corporate and personal taxes, costs of bankruptcy or financial distress do not exist. Demonstrate that either way of the dividend policy is irrelevant to the share price of the firm.Explanation / Answer
Alternative 1:
Firm has $20 Mn excess cash now and it hopes to generate $48 Mn FCFF in future so it can pay dividends of $4.8 per share in future.
Paying dividends of $2 per share with excess cash when FCFF = $48 Mn would result in cum-dividend price of share = Pcum-dividend = Current Dividend + Present value of Future Dividends
= $2 + PV($4.8) (in perpetuity)
= $2 + $4.8/0.12 = $2 + $40 = $42
Pcum-dividend = $42
Alternative 2:
Firm wants to start paying $4.8 per share right away and needs another $28 Mn in order to achieve that which it hopes do by issuing shares worth $28 Mn
Price per share = $42
Number of shares to be issued to raise $28 Mn = $28 Mn/42 = 0.67 Mn
Number of shares after shares issue = 10.67 Mn
Dividend per share then becomes lesser than expected because of increased number of shares
New Dividend = $48 Mn/ 10.67 Mn = $4.5 per share
Pcum-dividend = Current Dividend + Present value of Future Dividends
= $4.5 + PV($4.5) (in perpetuity)
= $4.5 + $4.5/0.12 = $4.5 + $37.5 = $42
This shows that either of the alternatives will result in same cum-dividend price of share for the firm.
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