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Part I:

Scenario for problem 1

1. The Frontczak Company is expecting to generate (after tax)a Net Income of $250 million annually and indefinitely (in perpetuity), and this amount is paid out annually as dividends.

The company’s stock has a βeta of 1.2, the risk free rate or return (RFR) is 4% and the market risk premium (MRP) is 6%.

The company is financed at a debt-to-value ratio of 0.4.  The company can borrow at a pre-tax cost of 6%, and the tax rate is 35%.  There are 10 million shares of common stock outstanding.

a) What is the stock price?

b) Suppose you are in a Modigliani–Miller(M&M) theorem world with taxes.

The firm is considering a levered recapitalization through an issue of $400 million in new 30-year debt (which is expected to be rolled over indefinitely - in perpetuity) and result in $24 million annually in interest payments.

The 2 options being considered for the $400 million debt proceeds are:

(1) use it to finance an open market stock buyback program and

(2) use it to pay a one-time special dividend.

The firm would announce the $400million recapitalization and its choice (1 or 2) simultaneously.

Suppose there is no extra information content to the announcement of the recapitalization and of the specific choice (1 or 2) – M&M with taxes world.  

(i) What do you expect to be the stock price upon announcement of the recapitalization and choice (1) versus the stock price upon announcement of the recapitalization and choice (2)?

(ii) Continuing, what do you expect to Bethe;

(a). Stock price and(b). Earnings per Share (EPS) after the completion of:

- repurchasing the shares
and alternatively,
-  paying out the special dividend.

Note: You need to find out and show the (a) Stock price and (b). EPS for both repurchasing the shares &- paying the special dividend.

Part II

Please circle the correct answer and then describe& justify your answer.

1) Leslie purchased 100 shares of GT, Inc. stock on Wednesday, June 7th.  Marti purchased 100 shares of GT, Inc. stock on Thursday, July 8th.

GT declared a dividend on June 20th to shareholders of record on July 12th and payable on August 1st.

Which one of the following statements concerning the dividend paid on August 1st is correct given this information?

A. Neither Leslie nor Marti are entitled to the dividend.
B. Leslie is entitled to the dividend but Marti is not.
C. Marti is entitled to the dividend but Leslie is not.
D. Both Marti and Leslie are entitled to the dividend.
E. Both Marti and Leslie are entitled to one-half of the dividend amount.

2) Allelse equal, the market value of a stock would tend to decrease by roughly the amount of the dividend on the:

A. dividend declaration date.
B. ex-dividend date.
C. date of record.
D. date of payment.
E. day after the date of payment.

3) Which one of the following is an argument in favour of a low dividend policy?

A. the tax on capital gains is deferred till the gain is realized
B. few, if any, positive net current value projects are available to the firm
C. a preponderance of stockholders has minimal taxable income
D. a majority of stockholders has other investment opportunities which offer higher rewards with similar risk characteristics
E. corporate tax rates exceed personal tax rates

4) Which of the following might tend to keep dividends low?

I. a state law restricting dividends in excess of retained earnings
II. a term contained in bond indenture agreements
III. the wish to maintain constant dividends over time
IV. flotation costs

A. II and III only
B. I and IV only
C. II, III, and IV only
D. I, II, and III only
E. I, II, III, and IV

5) Ignoring capital gains as the alternative, the tax law changes in 2003 (Cut in maximum tax rate on dividends to 15%) tend to favour a:

A. lower dividend policy.
B. constant dividend policy.
C. zero-dividend policy.
D. higher dividend policy.
E. restrictive dividend policy.

6) Which of the following are factors that favour a high dividend policy?

I. stockholders desire for current income
II. tendency for higher stock prices for high dividend paying firms
III. investor dislike of uncertainty
IV. high percentage of tax-exempt institutional stockholders

A. I and III only
B. II and IV only
C. I, III, and IV only
D. II, III, and IV only
E. I, II, III, and IV

7) An investor is more likely to prefer a high dividend payout if a firm:

A. has high flotation costs.
B. has few, if any, positive net present value projects.
C. has lower tax rates than investor.
D. has a stock price which is increasing rapidly.
E. offers high capital gains that are taxed at a favourable rate.

8) All else equal, a stock dividend would _____ the number of shares outstanding and _____ the value per share.

A. increase; increase
B. increase; decrease
C. not change; increase
D. decrease; increase
E. decrease; decrease

Basic Finance, Finance

  • Category:- Basic Finance
  • Reference No.:- M91832

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