ABC Inc. is an all-equity firm with no debt that is exempt from paying any taxes. The firm has CAD$100 thousand of assets (e.g. cash). It also expects to generate additional free cash flow of CAD$50 thousand per year into perpetuity starting from next year (assume that the investment has already been made and accounted for in the value of existing assets). The cost of assets of ABC (cost of equity of the unlevered firm) is 10% and there are 20thousand shares outstanding. The Board of Directors of ABC is planning to use the CAD$50 thousand of its cash on the balance sheet to either pay a special dividend or to repurchase the firm’s shares.
1. What will be the percentage change in the share price of ABC on the ex-dividend date if ABC uses CAD$50thousand to pay a special dividend?
2. If the firm uses CAD$50 thousand to repurchase some of its common stock and pays the entire free cash flow as regular dividends in the future, what would be the amount of such regular dividend per share?
Now assume that the Board of Directors of ABC has decided to use the CAD$50 thousand of its cash on the balance sheet to repurchase some of its common stock. You are an investor in ABC owning 5,000 shares of the firm’s common stock. However, you are unhappy with the decision of ABC’s Board of Directors about the stocker purchase and would have preferred that the firm used this money to pay a special dividend instead. You are also unhappy with the fact that ABC is an all-equity firm and would have preferred that the firm had debt with the 40% leverage ratio (as measured by D/V). The cost of debt (=interest rate) is 5%.
3. Show exactly how you can create a homemade dividend to get the same combination of cash and stock after the share repurchase as if ABC paid the special dividend.4.
4. Show exactly how you can create homemade leverage to get the same leverage ratio with your holdings as if the firm is levered as you had preferred (Hint: consider 3 different scenarios of perpetual annual cash flows (in thousands) starting in year 1: Recession: earnings=FCF=$40; Expected: earnings=FCF=$50; and Expansion: earnings=FCF=$60.)