1) House of Haddock has 5,000 shares outstanding and the stock price is $140. The company is expected to pay a dividend of $20 per share next year and thereafter the dividend is expected to grow indefinitely by 5% a year. The president, George Mullet, now makes a surprise announcement: He says that the company will henceforth distribute half the cash in the form of dividends and the remainder will be used to repurchase stock.
a. What is the total value of the company before and after the announcement? What is the value of one share?
b. What is the expected stream of dividends per share for an investor who plans to retain his shares rather than sell them back to the company? Check your estimate of share value by discounting this stream of dividends per share.
2) Here are key financial data for House of Herring, Inc.:
Earnings per share for 2015 $5.50
Number of shares outstanding 40 million
Target payout ratio 50%
Planned dividend per share $2.75
Stock price, year-end 2015 $130
House of Herring plans to pay the entire dividend early in January 2016. All corporate and personal taxes were repealed in 2014.
a. Other things equal, what will be House of Herring's stock price after the planned dividend payout?
b. Suppose the company cancels the dividend and announces that it will use the money saved to repurchase shares. What happens to the stock price on the announcement date? Assume that investors learn nothing about the company's prospects from the announcement. How many shares will the company need to repurchase?
c. Suppose the company increases dividends to $5.50 per share and then issues new shares to recoup the extra cash paid out as dividends. What happens to the with- and ex-dividend share prices? How many shares will need to be issued? Again, assume investors learn nothing from the announcement about House of Herring's prospects.
3) The common stock and debt of Northern Sludge are valued at $50 million and $30 million, respectively. Investors currently require a 16% return on the common stock and an 8% return on the debt. If Northern Sludge issues an additional $10 million of common stock and uses this money to retire debt, what happens to the expected return on the stock? Assume that the change in capital structure does not affect the risk of the debt and that there are no taxes.
Data
Number of shares 1,000
Price per share $10
Market value of shares $10,000
Outcomes
Operating income ($) 500 1,000 1,500 2,000
Earnings per share ($) .50 1.00 1.50 2.00
Return on shares (%) 5 10 15 20
Expected outcome
4) Use above chart. Suppose that Ms. Macbeth's investment bankers have informed her that since the new issue of debt is risky, debt holders will demand a return of 12.5%, which is 2.5% above the risk-free interest rate.
a. What are rA and rE?
b. Suppose that the beta of the unlevered stock was 0.6. What will βA, βE, and βD be after the change to the capital structure?