Question

Your firm will pay a dividend of $5.70 per share in perpetuity. The shareholders in your firm have a dividend tax rate of 40 percent. The tax rate on capital gains is 15 percent. The required rate of return on the company's stock is 11.3 percent compounded annually. Your firm has announced that it will no longer pay a dividend but will use the cash to repurchase shares. By how much will stock price change?

Answer 1

Sol:

Dividend payout = $5.70 per share

Dividend tax rate = 40%

Tax on capital gain = 15%

Required rate of return = 11.3%

To determine stock price change if the firm has announced that it will no longer pay a dividend but will use the cash to repurchase shares will be as follows.

Stock price = (Dividend payout / (1 + Dividend tax rate)) / (1+Tax on capital gain) x (1 + Required rate of return)

Stock price = (5.70 / (1 + 40%)) / (1+15%) x (1 + 11.3%)

Stock price = (5.70 / 1.40) / (1.15) x (1.113)

Stock price = (4.07 / 1.15) x 1.113

Stock price = 3.54 x 1.113 = $3.94

Therefore change in stock price will be $3.94