Case
A friend of yours is the CEO of a company called CSR delivering corporate social responsibility solutions. The company has grown quickly and it is since the 1st of January 2015 noted on the Stockholm Stock Exchange. Your friend knows you are a finance specialist and therefore consults you to analyze whether or not the company shall pay yearly dividends or not to its shareholders.
General
• The company has until now made yearly earnings before interest and taxes (EBIT) of $1.5million.
• Growth in EBIT is expected to be 4% annually.
• The corporate tax rate is expected to be 25% per year forever.
• The Company's current re, cost of equity capital, is 12%.
• The company expects to make profits for the next 10 years and then make zero profits forever.
• Today is the 1st of January 2015. Dividends and shares
• The total number of shares outstanding is 1 000 and the number is expected to remain fixed forever.
• The company considers paying no dividends at all, paying dividends of $100 per share and year or paying dividends of $200 per share and year.
Cost of dividends
• The transaction cost for issuing dividends amounts to $5 per share and dividend.
• There are no legal costs associated with dividends.
Your task
Your task is to create a spreadsheet model (using Microsoft Excel) showing your friend which alternative is to prefer. In particular your friend wants you to show her the following in the spreadsheet model:
a) Show by calculation what would be the price per share today for each of the three dividend alternatives (no dividend, $100 dividend, $200 dividend). Also, given the information above, explain which of the three alternatives the company (CSR) should choose in order to maximize company value.
b) Now assume that instead of paying dividends for years 2015 and 2016 the company can choose to invest today the amount equivalent to those two dividend payouts. The investment opportunity implies putting money into a financial security that will yield a 12% return per year for the next 10 years. Should the company make the investment or not in order to maximize company value? Show by computation!
c) Now assume a perfect capital market (according to Modigliani & Miller). The company considers repurchasing 100 shares today, January 1st 2015, instead of using that amount of money to pay dividends. Should the company repurchase shares or pay out dividends in order to maximize company value? Show by computation.