Question

Cabot Vineyards has been paying a regular cash dividend of $4.80 per share each year for over a decade. The company is paying out all its earnings as dividends and is not expected to grow. There are 118,000 shares outstanding selling for $80 per share. The company has sufficient cash on hand to pay the next annual dividend.
Suppose that, starting in year 1, Cabot decides to cut its cash dividend to zero and announces that it will repurchase shares instead.
a. What is the immediate stock price reaction? Ignore taxes and assume that the repurchase program conveys no information about operating profitability or business risk.

b. How many shares will Cabot re-purchase?

c. Project and compare future stock prices for the old and new policies for the next 3 years. What is the annual return to shareholders under each of the policies?

Answer 1

There are 118,000 shares outstanding. The cash dividend is $4.80 per share and the selling price is $80 per share. The company has enough cash to pay the dividends. The company wants to reduce the cash dividend each year and reduce it to zero. Instead the company would repurchase the shares. (a) The repurchase announcement does not exactly state or gives information about the overall performance of the company. Thus, there will be no change in the stock price. (b) Calculate the number of shares repurchased. Cash on hand =Cash dividend ~ Number of shares = $4.8x118,000 = $566,400 Cash on hand Number of shares repurchased =- Price per share $566,400 $80 = 7,080 Shares Thus, 7,080 shares are repurchased.

(C) The price increases by 6% ($4.8sso). Shares outstanding Time 0 118.000.00 | 110,920.00 104,641.51 99,053.68 Share Price Cash Shares repurchased (4.8xShares (Cash avaliable/Share (Pricex1.06) outstanding) price) $80.00 $566,400.00 7,080.00 $84.80 $532,416.00 6.278.49 $89.89 $502,279.25 5,587.83 $95.28 $475,457.64 4,990.04 2