Question

The Caraway Seed Company sells specialty gardening seeds and products primarily to​ mail-order and Internet customers. The firm has $216,000available for distribution as a cash dividend immediately and plans to shut down its business at the end of one​ year, at which time it will be prepared to pay a liquidating dividend of $1.41 million to the​ firm's stockholders. The​ firm's shareholders require a 9.8 percent rate of return for investing in the​ all-equity-financed firm.

a.  What do you estimate the value of​ Caraway's equity to be today if it pays out a ​$216,000 cash dividend today and plans to pay a $1.41million liquidating dividend at the end of the​ year?

b.  If​ Caraway's board of directors decides to pay a $608,000 dividend today to its existing shareholders using an equity offering selling new shares of common stock to raise the additional $392,000 it needs to make the cash​ dividend, what will be the value of the existing shares of​ stock? The new​ shares?

Answer 1

a) Value of equity = Dividend Today + (Dividend at the end of the year / Cost of capital)

= 216,000 + ( 1,400,000 / ( 1+0.098) ) = 1,500,153.005

b) Dividend today = 608,000

Issue of additional shares = 392,000

Cash dividend paid at the end of the year = 1,410,000 - [392,000 * (1+0.098)] = 1,410,000 - 430,416 = 979,584

Value of equity = Dividend Today + (Dividend at the end of the year / Cost of capital)

= 608,000 + ( 979,584 / ( 1+0.098) ) = 1,500,153.005

Value of new shares = 392,000