Singapore Management University

FNCE201 Corporate Finance

Term 1 2019/20
Practice Questions 7: Payout 1

1. EJH Company has a market capitalization of $1 billion and 20 million shares out-
standing. It plans to distribute $100 million through an open market repurchase.
Assuming perfect capital markets:

(a) What will the price per share of EJH be right before the repurchase?

Solution: $1 billion/20 million shares = $50 per share.

(b) How many shares will be repurchased?

Solution: $100 million/$50 per share = 2 million shares.

(c) What will the price per share of EJH be right after the repurchase?

Solution:
If markets are perfect, then the price right after the repurchase should be
the same as the price immediately before the repurchase. Therefore the price
will be $50 per share.

2. KMS Corporation has assets with a market value of $500 million, $50 million of which
are cash. It has debt of $200 million, and 10 million shares outstanding. Assume
perfect capital markets.

(a) What is its current stock price?

Solution: (500 – 200)/10 = $30

(b) If KMS distributes $50 million as a dividend, what will its share price be after
the dividend is paid?

Solution: (450 – 200)/10 = $25

 (c) If instead, KMS distributes $50 million as a share repurchase, what will its share
price be once the shares are repurchased?

Solution: (450 – 200)/(10 – 1.667) = $30

(d) What will its new market debt-equity ratio be after either transaction?

Solution: 200/250 = 0.8

3. Suppose that all capital gains are taxed at a 25% rate, and that the dividend tax
rate is 50%. Arbuckle Corp. is currently trading for $30, and is about to pay a $6
special dividend.

(a) Absent any other trading frictions or news, what will its share price be just after
the dividend is paid?

Solution:
τd∗ = (0.5–0.25)/(1–0.25) = 0.333
Pex = 30–6(1–0.333) = $26

Suppose Arbuckle made a surprise announcement that it would do a share re-

purchase rather than pay a special dividend.

(b) What net tax savings per share for an investor would result from this decision?

Solution:
With dividends, the tax would be 6×50% = $3 for dividends, with a tax
savings of 4 ×25% = $1 for capital loss, for a net tax from the dividend of $2
per share. This amount would be saved if Arbuckle does a share repurchase
instead.

(c) What would happen to Arbuckle’s stock price upon the announcement of this
change?

Solution: Stock price rises to by $2 to $32 to reflect the tax savings.

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4. Natsam Corporation has $250 million of excess cash. The firm has no debt and 500
million shares outstanding, with a current market price of $15 per share. Natsam’s
board has decided to pay out this cash as a one-time dividend

(a) What is the ex-dividend price of a share in a perfect capital market?

Solution:
The dividend payoff is $250/$500 = $0.50 on a per share basis. In a perfect
capital market the price of the shares will drop by this amount to $14.50.

(b) If the board instead decided to use the cash to do a one-time share repurchase,
in a perfect capital market what is the price of the shares once the repurchase
is complete?

Solution: $15

5. The table below presents the tax rates for capital gains and dividends between 1987
and 2009.

Year(s) Capital Gains Dividends

1987 28% 39%
1988–1990 28% 28%
1991–1992 28% 31%
1993–1996 28% 40%
1997–2000 20% 40%
2001–2002 20% 39%
2003–2009 15% 15%

Find the effective dividend tax rates for 1989 and 1999.

Solution:
Effective tax rate for 1989

τd − τg 0.28 − 0.28
τd∗ = = = 0 or 0%
1 − τg 1 − 0.28

Effective tax rate for 1999

τd − τg 0.40 − 0.20
τd∗ = = = 0.25 or 25%
1 − τg 1 − 0.20

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6. Wyatt Oil has assets with a market value of $600 million, $70 million of which are
cash. It has debt of $250 million, and 20 million shares outstanding. Assume perfect
capital markets.

(a) What is Wyatt Oil’s current stock price?

Solution:
Price = (Assets-Debt)/Shares outstanding = (600-250)/20 = $17.50

(b) What is Wyatt Oil’s stock price after it distributes the $70 million as a dividend?

Solution:
Price = (Assets-Debt-Dividend)/Shares outstanding = (600-250-70)/20 =
$14.00

(c) If Wyatt Oil distributes the $70 million as a share repurchase instead, what
would its stock price be after the share repurchase?

Solution:
Price = (Assets-Debt)/Shares outstanding = (600-250)/20 = $17.50 There-
fore Wyatt Oil will repurchase $70 million/$17.50 = 4 million shares, leaving
20−4=16 million shares outstanding. After the repurchase, its stock price =
(Assets-Debt)/Shares outstanding = (600−70−250)/16 = $17.50

(d) What is the debt-to-equity ratio for Wyatt Oil after it distributes the $70 million
as a dividend.

Solution:
Equity = Assets − Debt. After the distribution, Assets = 600−70 = 530, so
Equity = 530 − 250 = $280 million. The debt-to-equity ratio = $250/$280
= 0.893

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7. The HNH Corporation will pay a constant dividend of $2 per share, per year, in
perpetuity. Assume all investors pay a 20% tax on dividends and that there is no
capital gains tax. Suppose that other investments with equivalent risk to HNH stock
offer an after-tax return of 12%.

(a) What is the price of a share of HNH stock?

Solution: P = $1.60/0.12 = $13.33

(b) Assume that management makes a surprise announcement that HNH will no
longer pay dividends but will use the cash to repurchase stock instead. What is
the price of a share of HNH stock now?

Solution: P = $2/0.12 = $16.67

8. Que Corporation pays a regular dividend of $1 per share. Typically, the stock price
drops by $0.80 per share when the stock goes ex-dividend. Suppose the capital
gains tax rate is 20%, but investors pay different tax rates on dividends. Absent
transactions costs, what is the highest dividend tax rate of an investor who could
gain from trading to capture the dividend?

Solution:
Because the stock price drops by 80% of the dividend amount, shareholders are
indifferent if τd∗ = 20%.
Using the formulation for τd∗ , τd = τg + τd∗ (1–τg ) = 36%. Investors who pay a
lower tax rate than 36% could gain from a dividend capture strategy.

9. Taggart Transcontinental shares are currently trading at $200 per share. The split
ratio needed to bring the stock price down to $80 is closest to:
A. 2:1
B. 3:1
C. 2:5
D. 5:2

Solution:
The ratio needed is 200/80 = 20/8 = 10/4 = 5/2 or 5:2 in simplest form.

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10. Luther Industries currently has 5 million shares outstanding and its stock is currently
trading at $40 per share.
(a) Assuming Luther issues a 25% stock dividend, what is Luther’s new share price?

Solution: New share price $40/1.25=$32

(b) Assuming Luther issues a 5:2 stock split, what is Luther’s new share price?

Solution: New share price = $40/(5/2)=$16

(c) Assuming Luther issues a 5:2 stock split, what is the number of shares Luther
will have outstanding following the split?

Solution:
Shares outstanding following split = Current Shares Outstanding×Split
= 5 million×(5/2) = 12.5 million

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