Question 4
Company C has been paying a regular cash dividend of $4 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 100,000 shares outstanding selling for $80 per share. The company has sufficient cash on hand to pay the next annual dividend. Suppose that Company C decides to cut its cash dividend to zero and announce that it will repurchase shares instead.
Required:
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. (4 marks)
b) How many shares will Company C purchase? (2 marks)
c) If a firm borrows $50 million for one year at an interest rate of 9%, what is the present value of the interest tax shield? Assume a 30% marginal corporate tax rate. (4 marks)
d) Discuss how dividend policy is affected using clientele effect theory, signal effect theory and tax effect theory. (12 marks)