AFM 274 Practice Problem Set #4 Spring 2023

Suggested Solutions

Textbook Questions

20.6 (a) The share price is ($500,000,000 − $200,000,000) ÷ 10,000,000 = $30

(b) The share price is ($500,000,000 − $50,000,000 − $200,000,000) ÷ 10,000,000 = $25.

(c) The number of shares left after the repurchase is 10,000,000 − $50,000,000 ÷ $30 = 8,333,333.33,
so the share price then is ($500,000,000 − $50,000,000 − $200,000,000) ÷ 8,333,333.33 = $30.

(d) If the $50 million is paid out as a dividend, then there will be 10 million shares outstanding at a
price of $25. Therefore, the total value of the firm’s equity will be $250 million. Given the debt
level of $200 million, this implies a debt-equity ratio of 0.80. If the $50 million is used to
repurchase shares, there will be 8,333,333.33 shares outstanding at a price of $30, giving a total
value of equity of $250 million. Therefore, the debt-equity ratio will again be 0.80.

20.7 (a) In a perfect capital market, the share price will drop by the amount of the dividend. Since the
dividend paid per share in this case is $250,000,000 ÷ 500,000,000 = $0.50, the share price will
drop from $15 to $14.50.

(b) The total value of the firm’s assets will be 500,000,000 × $15 − $250,000,000 = $7.25 billion.
The number of shares repurchased is $250,000,000 ÷ $15 = 16,666,666.67, leaving
483,333,333.33 shares outstanding. Dividing $7.25 billion by this number of shares gives a share
price of $15.

(c) In a perfect capital market, investors are not better off with either a dividend or a repurchase. In
the case of the dividend, a shareholder who owns 100 shares has an investment worth $1,500
before the dividend. Once the dividend is paid, this shareholder has shares worth $1,450 plus $50
worth of dividends. In the case of a repurchase, if the investor sells the 100 shares back to the
firm, cash of $1,500 is received. If the investor holds onto the shares, they are worth a total of
$1,500. No matter what happens, the investor’s position is worth a total of $1,500 before the
dividend or repurchase and it is worth the same amount afterwards.

20.8 Suppose that you own N shares. If the firm had paid the dividend of $0.50 per share, you would have
received cash of N × $0.50 and you would have had shares worth N × $14.50 after the dividends were
paid. If the firm repurchases shares, you need to sell some of your shares in order to obtain the same
amount of cash. Since the shares are repurchased for $15 each, to receive total cash of N × $0.50, you
must sell N × $0.50/$15 shares. Since this implies that the fraction of your original N shares that you sell
is $0.50/$15, the number of shares you will have left is N (1 − $0.50/$15). At a share price of $15, your
shares will be worth

$15 − $0.50
𝑁𝑁 × � � × $15 = 𝑁𝑁 × $14.50
$15

Therefore, you will be in exactly the same position as if the firm had paid the dividend, in that you will
have the same amount of cash and the total value of shares that you will end up with will also be the
same. As a check, consider the particular case where N = 100. If the firm pays the dividend, you will
have $50 of cash and shares worth 100 × $14.50 = $1,450. If the firm repurchases shares, then you can
sell 100($0.50/$15) = 3.33 shares. At a price of $15, this will give you $50 of cash. You will have 96.67

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 shares remaining. At the price of $15, this investment is worth a total of $1,450.

20.9 The payoff of the option depends on Oracle’s future stock price, and the payoff is higher when the
firm’s stock price is higher. Therefore you would prefer share repurchases, since repurchases avoid the
price declines that follow dividend payments.

20.12 (a) The effective dividend tax rate is

𝜏𝜏𝑑𝑑 − 𝜏𝜏𝑔𝑔 . 50 − .25
𝜏𝜏𝑑𝑑∗ = = = 33.33%
1 − 𝜏𝜏𝑔𝑔 1 − .25

Therefore, the drop in price at the ex-dividend date is $6(1 − .3333) = $4. Given the original share
price of $30, the ex-dividend price is therefore $26.

(b) With a $6 dividend per share, the investor would pay tax of $3 per share since the dividend tax
rate is 50%. There would also be a capital loss of $4 per share due to the stock price drop. Given
the capital gains tax rate of 25%, this implies a tax benefit of $1 per share. With a repurchase, the
investor would save the dividend tax but lose the capital loss tax benefit, so the net tax saving is
$2 per share.

(c) The stock price would rise by $2 per share to $32 to reflect the tax saving.

20.16 Suppose the investor buys the stock just before it goes ex-dividend for the price 𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐 , holds the stock to
capture the dividend of $1, and then sells the stock for the ex-dividend price of 𝑃𝑃𝑒𝑒𝑒𝑒 . The total after tax
cash flows from this strategy would be

−𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐 + 𝑃𝑃𝑒𝑒𝑒𝑒 + 𝐷𝐷𝐷𝐷𝐷𝐷 × (1 − 𝜏𝜏𝑑𝑑 ) + (𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑃𝑃𝑒𝑒𝑒𝑒 )𝜏𝜏𝑔𝑔

price paid price received after tax dividend capital loss tax benefit

In this case, 𝜏𝜏𝑔𝑔 = 20%, 𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑃𝑃𝑒𝑒𝑒𝑒 = $0.80, and 𝐷𝐷𝐷𝐷𝐷𝐷 = $1. Setting the total after tax cash flows from
this strategy to be positive gives:

−$0.80 + $1(1 − 𝜏𝜏𝑑𝑑 ) + $0.80(. 20) > 0 ⇒ $1(1 − 𝜏𝜏𝑑𝑑 ) > $0.64 ⇒ 𝜏𝜏𝑑𝑑 < 0.36

In other words, as long as the investor faces a dividend tax rate of less than 36%, this strategy will be
profitable (given the other assumptions about the ex-dividend date price drop and the capital gains tax
rate).

20.18 (a) The increase in the regular annual dividend would be .10 × $50,000,000 ÷ 10,000,000 = $0.50.
This increase can only take effect starting in one year, because interest has to be earned before it
can be paid out. Therefore, with an increase in the regular dividend, cash flows from holding a
share would be:

Period 0 1 2 …
Increased regular dividend $0.50 $1.00 $1.00 …

If the company pays out the special dividend, then cash flows would be:

Period 0 1 2 …
Special dividend $5.50 $0.50 $0.50 …

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 If the special dividend is paid, then a shareholder who prefers the increase in the regular dividend
can take the extra $5 and invest it to earn 10%, i.e. $0.50 per year. This will result in the same
overall cash flows as for the increased regular dividend:

Period 0 1 2 …
Special dividend $5.50 $0.50 $0.50 …
Invest $5 -$5.00 $0.50 $0.50 …
Total $0.50 $1.00 $1.00 …
(b) If the firm increases its regular dividend, then a shareholder who prefers the special dividend can
borrow $5 today at 10% interest, i.e. $0.50 per year. This will produce the same overall cash
flows as the special dividend:

Period 0 1 2 …
Increased regular dividend $0.50 $1.00 $1.00 …
Invest $5 $5.00 -$0.50 -$0.50 …
Total $5.50 $0.50 $0.50 …

20.19 (a) In this setting with perfect capital markets (in particular, all tax rates are zero), we do not need to
consider the effective tax disadvantage of retaining cash. However, for consistency with problems
20.20 and 20.21, note that
∗
𝑉𝑉𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 𝑉𝑉𝑝𝑝𝑝𝑝𝑝𝑝 𝑜𝑜𝑢𝑢𝑢𝑢 × (1 − 𝜏𝜏𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 )

where the effective tax disadvantage of retaining cash is

∗
(1 − 𝜏𝜏𝐶𝐶 )�1 − 𝜏𝜏𝑔𝑔 �
𝜏𝜏𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = �1 − �
1 − 𝜏𝜏𝑖𝑖
∗
Given that 𝜏𝜏𝑐𝑐 = 𝜏𝜏𝑔𝑔 = 𝜏𝜏𝑖𝑖 = 0, then 𝜏𝜏𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 0. This means that the firm value will not change if
the firm announces that it will pay out the cash as opposed to retaining it. Consider why this
makes sense. Under the current plan where the firm retains the $100 million, the total dividend
paid out each year to investors is 7% of that amount, or $7 million. If the firm were to pay out the
$100 million as a one-time dividend, then investors could take that amount and invest it to earn
7%, or $7 million per year. In the first case, the firm is paying out a stream of dividends which has
a present value of $100 million. In the second case, it pays out $100 million (and this allows
investors to create the same stream of dividend on their own). Therefore, there will be no change
in the value of the firm when it announces that it will pay the one-time dividend.

(b) In the general case with non-zero tax rates, the change in the value of a share when a dividend is
paid is

1 − 𝜏𝜏𝑑𝑑
∆𝑃𝑃 = 𝐷𝐷𝐷𝐷𝐷𝐷 × � �
1 − 𝜏𝜏𝑔𝑔

In this case, since 𝜏𝜏𝑑𝑑 = 𝜏𝜏𝑔𝑔 = 0, the change in value is the full amount of the dividend. In terms of
the total firm value, the change will be the aggregate dividend that has been paid out. Therefore,
in this case the value of the firm will fall by $100 million on the ex-dividend date (Strictly
speaking, it will fall by the present value of $100 million, since the payment will not happen until

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 the payment date, which will be a short time after the ex-dividend date. Given the short time
between these two dates, the effect of the time value of money will be quite small.)

(c) This decision neither helps nor hurts the shareholders. If the firm retains the cash, the shareholders
hold an extra $100 million of equity in the firm. If it pays out the cash, the shareholders receive an
extra $100 million. This is reflected in the fact that firm value does not change upon the
announcement of the decision to switch from retaining the $100 million to paying it out as a
dividend.

20.20 (a) If 𝜏𝜏𝐶𝐶 = 35% and 𝜏𝜏𝑔𝑔 = 𝜏𝜏𝑖𝑖 = 0, then the effective tax disadvantage of retaining cash will be

∗
(1 − 𝜏𝜏𝐶𝐶 )�1 − 𝜏𝜏𝑔𝑔 �
𝜏𝜏𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = �1 − � = 𝜏𝜏𝐶𝐶 = 35%
1 − 𝜏𝜏𝑖𝑖

This implies that firm value will rise by 35% of the $100 million of cash, i.e. by $35 million, upon
the announcement of the change. For further intuition, note that if the firm pays a corporate tax
rate of 35%, then the annual dividend that it can pay out if it keeps the $100 million invested in
Treasury bills is $100(.07)(1 − .35) = $4.55 million. If the $100 million was paid out to the
shareholders, they could invest at 7% and earn $7 million per year, which is $2.45 million more
than if the firm does not pay out the $100 million. The present value of this amount is $2.45/.07 =
$35 million, so the value of the firm will rise by $35 million when the change in policy is
announced.

(b) As in problem 20.19, on a per share basis ∆P = Div since 𝜏𝜏𝑑𝑑 = 𝜏𝜏𝑔𝑔 = 0. Therefore, the value of the
firm will fall by the total dividend paid out of $100 million on the ex-dividend date.

(c) This decision benefits investors because they can obtain higher dividends every year by investing
the $100 million themselves, rather than having the firm invest it and pay corporate taxes on the
interest it earns.

20.21 (i) (a) If 𝜏𝜏𝑑𝑑 = 15%, and 𝜏𝜏𝐶𝐶 = 𝜏𝜏𝑔𝑔 = 𝜏𝜏𝑖𝑖 = 0, then

∗
(1 − 𝜏𝜏𝐶𝐶 )�1 − 𝜏𝜏𝑔𝑔 �
𝜏𝜏𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = �1 − �=0
1 − 𝜏𝜏𝑖𝑖

This implies that the firm value will not change upon the announcement. This makes sense
because the only tax rate here which is not zero is the tax rate on dividends, which must be
paid regardless of whether the firm retains the $100 million and pays out interest earnings
on it as a dividend or whether the $100 million is paid out and the investor (having paid the
dividend tax rate on it) then earns interest. In particular, if the firm retains the cash, it earns
$7 million of interest which is paid out to investors each year. Investors have to pay a 15%
dividend tax rate, so the after tax dividend is $7 × .85 = $5.95 million. On the other hand, if
the firm pays out $100 million as a dividend, the investor gets to keep $85 million after tax.
Annual interest on this amount at a rate of 7% is $5.95 million. Either way, the investors
end up with the same amount of cash, so there is no change in value at the announcement
date.

1−𝜏𝜏𝑑𝑑
(b) On a per share basis, ∆𝑃𝑃 = 𝐷𝐷𝐷𝐷𝐷𝐷 × . Given that 𝜏𝜏𝑑𝑑 = .15 and 𝜏𝜏𝑔𝑔 = 0, ∆P = Div×0.85. In
1−𝜏𝜏𝑔𝑔
terms of total firm value, the change is therefore 0.85 × $100 = $85 million. The drop in

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 firm value of $85 million reflects the after tax value of the total dividend payment.

(c) Since there is no change in the value of the firm when the decision is announced, this
decision neither hurts nor helps the investors.

(ii) (a) If 𝜏𝜏𝑑𝑑 = 𝜏𝜏𝑔𝑔 = 15% and 𝜏𝜏𝐶𝐶 = 𝜏𝜏𝑖𝑖 = 35%, then

∗
(1 − 𝜏𝜏𝐶𝐶 )�1 − 𝜏𝜏𝑔𝑔 � (1 − .35)(1 − .15)
𝜏𝜏𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = �1 − � = �1 − � = 15%
1 − 𝜏𝜏𝑖𝑖 1 − .35

This implies that the firm value should increase upon the announcement by 0.15 × $100 =
$15 million. To gain further insight into this value, suppose that the $100 million is retained
and invested at 7%. At the corporate level, the $7 million of interest is taxed at 35%,
leaving $4.55 million to be paid out as a dividend. Investors get to keep 85% of this after
tax, or $3,867,500. Alternatively, if the $100 million is paid out as a dividend, investors get
to keep $85 million after dividend taxes are paid. Earning interest at the rate of 7% gives
$5.95 million per year, but 35% of this goes to pay tax, leaving $3,867,500. Therefore,
under either alternative, the after tax income received by the investor is the same. However,
in this case there is an additional benefit. The firm value will drop by $100 million on the
ex-dividend date (see part (b) below), and with 𝜏𝜏𝑔𝑔 = 15%, there will be a tax loss benefit of
$15 million. This accounts for the increase in firm value at the announcement date.

1−𝜏𝜏𝑑𝑑
(b) On a per share basis, ∆𝑃𝑃 = 𝐷𝐷𝐷𝐷𝐷𝐷 × . Since 𝜏𝜏𝑑𝑑 = 𝜏𝜏𝑔𝑔 = 15%, ∆P = Div. Therefore, firm
1−𝜏𝜏𝑔𝑔
value will fall at the ex-dividend date by the total dividend paid out of $100 million.

(c) As reflected in the rise in firm value on the announcement date, this is beneficial for
investors because of the capital loss tax benefit.

20.29 (a) With a stock dividend of 20%, each existing share will become 1.2 shares. The new share price
will be $20 ÷ 1.2 = $16.67. (For example, before the stock dividend an investor holding 5 shares
had a position worth $100. After the stock dividend, this investor has 6 shares that are still worth
$100, and $100 ÷ 6 = $16.67.)

(b) With a 3:2 stock split, each existing share will become 1.5 new shares. The new share price is $20
÷ 1.5 = $13.33. (As an example, an investor who holds 2 shares that are worth a total of $40
before the split ends up with 3 shares that are worth $40 in total, corresponding to a price per
share of $13.33.)

(c) With a 1:3 reverse stock split, each existing share will become 1/3 of a new share, so the new
share price is $20 ÷ 1/3 = $60. (Consider an investor holding 3 shares prior to the reverse split.
This position is worth a total of $60. After the reverse split, the investor’s position is still worth
$60 but this investor has just one share.)

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 Additional Questions

1. Let 𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐 denote the share price right before the stock goes ex-dividend and let 𝑃𝑃𝑒𝑒𝑒𝑒 denote the share price as soon
as the stock is ex-dividend. Also let Div be the dollar amount of the dividend per share, and denote the dividend
and capital gains tax rates by 𝜏𝜏𝑑𝑑 and 𝜏𝜏𝑔𝑔 respectively. Then, in general we have

1 − 𝜏𝜏𝑑𝑑
∆𝑃𝑃 = 𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑃𝑃𝑒𝑒𝑒𝑒 = 𝐷𝐷𝐷𝐷𝐷𝐷 × � �
1 − 𝜏𝜏𝑔𝑔

(a) When 𝜏𝜏𝑑𝑑 = 𝜏𝜏𝑔𝑔 = 0, ∆𝑃𝑃 = $10

(b) With 𝜏𝜏𝑑𝑑 = 10%, ∆𝑃𝑃 = $10(1 − .10) = $9

(c) $10(1−.10)
With 𝜏𝜏𝑑𝑑 = 10% and 𝜏𝜏𝑔𝑔 = 15%, ∆𝑃𝑃 = = $10.59
1−.15

2. (a) The value of the firm is:

$500,000 − $200,000 $800,000
𝑉𝑉0 = + = $853,151
1.16 1.162
The share price is then:
$853,151
𝑃𝑃0 = = $8.53151
100,000

(b) The total dividend paid is $300,000. Since Margaret owns 10% of the firm, she receives $30,000. To
reduce this to $15,000 she should purchase $15,000 worth of additional shares at the end of year 1. The
firm value then is:

$800,000
𝑉𝑉1 = = $689,655
1.16
This implies a share price of:
$689,655
𝑃𝑃1 = = $6.89655
100,000
This means that Margaret should purchase $15,000/$6.89655 = 2,175 more shares. She would then own
12,175/100,000 or 12.175% of the firm.

(c) The firm would need to reduce its dividend payout at the end of year 1 to $150,000, implying that it
must repurchase $150,000 worth of shares at that time. The value of the firm is $689,655 (from part
(b)), plus the $150,000 to be used for the share repurchase. This gives a total of $839,655, and a share
price of $8.39655. Therefore, the firm should repurchase $150,000/$8.39655 = 17,864.48 shares,
leaving 82,135.52 shares outstanding. Margaret would own 10,000/82,135.52 or 12.175% of the firm.

3. (a) Firm value:

$20,000,000 − $10,000,000 $24,000,000
𝑉𝑉0 = + = $25,000,000
1.2 1.22
Share price: $25,000,000 ÷ 2,000,000 = $12.50.

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(b) Since you own 25% of the firm, you have 500,000 shares. The firm is currently paying a dividend of
$10,000,000 ÷ 2,000,000 = $5 per share, so you will be receiving $2.5 million rather than your desired
level of $3.5 million (corresponding to a dividend per share of $7). If the firm is to raise its dividend by
$2 per share, it needs to sell new shares worth $2 × 2,000,000 = $4 million. In order to obtain the 20%
required return, the new shareholders must receive $4,000,000(1.2) = $4,800,000 at the end of the
second year. This leaves $24,000,000 − $4,800,000 = $19,200,000 for the original shareholders. This
means that the dividend paid after two years must be $19,200,000 ÷ 2,000,000 = $9.60, implying that
the ex-dividend share price after one year is $9.60/1.2 = $8. The number of new shares issued is
therefore $4,000,000/$8 = 500,000. Since there would then be 2,500,000 shares outstanding, you would
own 20% of the firm. Note that your income would be $7 × 500,000 = $3.5 million after one year and
$9.60 × 500,000 = $4.8 million after two years.

(c) If the firm does not change its dividend policy, then the per share dividend paid out after two years is
$24,000,000 ÷ 2,000,000 = $12, and the ex-dividend share price after one year is $12/1.2 = $10. Under
this policy, after one year you will receive $2.5 million instead of $3.5 million. To obtain an extra $1
million, you will need to sell $1,000,000/$10 = 100,000 shares. You would then own 400,000 ÷
2,000,000 = 20% of the firm. Note that your income would be $5 × 500,000 + $1,000,000 = $3.5
million after one year and $12 × 400,000 = $4.8 million after two years, exactly as in part (b).