Question

Consolidated Pasta is currently expected to pay annual dividends of $10 a share in perpetuity on the 1.6 million shares that are outstanding. Shareholders require a 8% rate of return from Consolidated stock.

a. What is the price of Consolidated stock? (Do not round intermediate calculations.)

b. What is the total market value of its equity? (Enter your answer in millions.)

Consolidated now decides to increase next year’s dividend to $20 a share, without changing its investment or borrowing plans. Thereafter the company will revert to its policy of distributing $10 million a year.

c. How much new equity capital will the company need to raise to finance the extra dividend payment? (Enter your answer in millions.)

d. What will be the total present value of dividends paid each year on the new shares that the company will need to issue? (Enter your answer in millions.)

e. What will be the transfer of value from the old shareholders to the new shareholders? (Enter your answer in millions.)

f. Is this figure more than, less than, or the same as the extra dividend that the old shareholders will receive?

• More than

• Less than

• The same

Answer 1

a). Price of stock = annual dividend/return on stock = 10/8% = 125 per share

b). Total market value of equity = price per share*number of shares

= 125*1.6 million = 200 million

c). New equity capital required = increase in dividend*number of shares

= (20-10)*1.6 million = 16 million

d). The amount of investment required is 16 million so the total present value of the dividends paid each year on the new shares will be 16 million, only.

e). The transfer of value from old shareholders to the new shareholders is the same as the new capital raised which is 16 million.

f). It is the same as the extra dividend that old shareholders will receive since firm value does not change. As number of shares increase, the stake value of old shareholders decreases.