Question :

Alpha Ltd. - an 100% equity company - is following a payout ratio of 40% during the last several years. The financial managers of the company are now considering whether they should reduce the payout ratio to 20% (for dividend purpose) and use the remaining 20% for stock repurchase for the next year. It would like you to examine the impact of the change in policy on its stock prices after taking into the following facts.

(i) Before tax required rate of return by the equity shareholders is 15%

(ii) Current year EPS was Rs. 10 and the company has just paid a dividend of Rs. 4 per share.

(iii) Historical growth rate of EPS and dividend were 9%

(a) Compute the current market price of the stock before initiating such policy change.

(b) What will be the impact of the above policy change on the stock price? Compute the expected market price that will prevail after the announcement of policy change.

(c) Suppose the company has decided not to declare any dividend nor any stock repurchase. It retains all profits and re-invests in projects that offer 15% return.

What will be impact of such change in dividend policy on the stock price if dividends are taxed at 30% and capital gains are taxed at 10%?