Question

Big Industries has the following market-value balance sheet. The stock currently sells for $20 a share, and there are 1,000 shares outstanding. The firm will either pay a $1 per share dividend or repurchase $1,000 worth of stock. Ignore taxes.

Assets		Liabilities and Equity
Cash	$2,000	Debt	$10,000
Fixed assets	28,000	Equity	20,000

What will be the price per share under each alternative (dividend versus repurchase)? (4 Marks)

If total earnings of the firm are $2,000 a year, find earnings per share under each alternative.

Find the price-earnings ratio under each alternative.

Answer 1

a). If the firm pays a dividend,

The stock price = $20 -$1 = $19 per share.

The number of shares is still 1,000 shares

If the firm repurchases stock,

The market value of equity = $20,000 - $1,000 = $19,000

The number of shares will fall by: $1,000/$20 = 50 shares

The stock price will remain at: $19,000/950 = $20 per share

b). If the firm pays a dividend,

earnings per share = $2,000/1,000 = $2

If the firm repurchases stock, then: EPS = $2,000/950 = $2.105

c). If the dividend is paid,

The price-earnings ratio = $19/$2 = 9.50

If the stock is repurchased,

The price-earnings ratio = $20/$2.105 = 9.50