Part III: Simple Valuation and Financing Analysis

Consider a firm with no debt and that pays no corporate level taxes (like a real estate investment trust). Also assume that we are in a world much like that assumed by Miller & Modigliani (no transaction costs, all investors and managers equally informed and the level of operating cash flows are fixed regardless of financing decisions). The firm currently has no debt. The firm has $60 million in cash on hand and a steady operating cash flow (earnings) that is expected to be $60 million a year forever (in perpetuity). Assume the Capital Asset Pricing Model holds, that the risk free rate is 4% and the market risk premium is 4% and the beta of the stock will equal 1 after the any dividends are paid. Hence, the cost of equity for this firm is Rf + beta x Risk premium which equals 4% + 1 x 4% = 8%. There are 100 million shares of stock outstanding.

a) The firm anticipates that it will pay a dividend of $60 million in one day from cash on hand and in the future will pay out all cash flow that it generates as a dividend at the end of each year ($60 million expected value).

i) What should the firm's stock price and stock value (price x shares outstanding) before it pays the dividend

ii) What should the firm's stock price and stock value (price x shares outstanding) immediately after it pays the dividend

iii) Immediately after it pays the dividend what is the expected earnings per share for the stock for the next year?

iv) If the firm had opted to buy back $60 million of stock at the price of the stock in part i), how many shares of stock would there be and what would the expected earnings per share for the upcoming year?

v) If the earnings are expected to be higher in the upcoming year, shouldn't the price to earnings ratio after the payout be higher because of more earnings growth. Explain your answer briefly.

b) Assume the firm decides to pay a one-time unusually high dividend of $210 million tomorrow instead of $60 million and finances it by using the $60 million of cash on hand and by issuing $150 million of highly rated "risk free" debt that has a beta of 0 and an annual interest rate of 4%. The debt is "perpetual debt" meaning it has no maturity date and pays out 4% interest forever. The firm will pay out whatever it earns in profits from operations less interest on debt as a dividend at the end of each year. Answer the following questions and show your work:

i) What would be the new beta of the firm's stock after the dividend is paid?

ii) If the cash flows the firm generates are equal to earnings and if there were 1 share outstanding, what was the old level of earnings per share and what is the new level?

iii) What would the market value of the firm's stock be after paying the special dividend with the aid of debt financing?

iv) Can you explain why an increase or decrease in earnings per share from the firm's change in financial policy does not necessarily translate into a similar movement up or down in the shareholders total value (dividend plus stock value)?

Attachment:- Assignmentt.rar