Question

Company ABC has 10,000 shares outstanding and the stock price is $100. The company is expected to pay a dividend of $10 per share next year and thereafter the dividend is expected to grow indefinitely by 6% a year. The company now makes an announcement: It will repurchase shares next year instead of issuing cash dividends. But from year 2 on the payout policy stays the same with cash dividends.

(Please check my work A - C, and solve for D) (Please show your work)

a. What is the expected rate of return on the stock?

Stock price = Dividend per share / (cost of capital equity - dividend growth rate)

100 = 10 / (cost of equity - 6%) = Required rate of return = 16%

b. At what price will the company repurchase shares next year? How many shares will be repurchased?

purchase price = current price*(1+required rate) = 100*(1+0.16) = 116

number of shares repurchased = dividend * shares outstanding / price = 10*10000/116= 862.07

c. After the payout, what is the percentage ownership of an investor who holds 1% of the shares before the payout and does not sell shares during the repurchase?

number of shares owned = 1% of total shares = 10000*0.01 = 100

new owership percentage = shares owned/(total shares-shares repurchased) =100/(10000-862.07)=1.094%

d. Will this investor prefer cash dividend or stock repurchase? Please show your calculation.

Answer 1