You have become the new CEO of Iqbal & Associates (the last CEO didn’t know what he was doing). The last CEO did some thinking on borrowing, but left you with no advice on dividend policy. You want to know what happens to your stock price as a result of returning money to investors. You know the following: i) You are planning to declare a dividend of $0.40, on which investors face a tax rate of 35%; ii) Investors pay a capital gains tax of 35%, which can be deferred to future years; iii) Investors have an opportunity cost of 8.5% in evaluating future cash flows.

(a) If the price of one share of I&A (before the ex-dividend date) is $27, assuming the average investor defers taxes for 4 years, what will the price be right after the ex-dividend day?

(b) Assume now that the majority of your investors are corporations who face a capital gains tax of 35% and a 42.5% ordinary tax on income (including dividends). Also assume now that, instead of being able to defer taxes, investors are allowed to exempt 65% of the dividends they receive from taxes. If the shares are selling at $27 each, how much will the stock price drop by by the end of the ex-dividend day?

(c) Explain intuitively why the price of the stock changes on the ex-dividend day.