Question

The JRN Corporation will pay a constant dividend of $3 per share, per year, in perpetuity. Assume that all investors pay a 20% tax on dividends and that there is no capital gains tax. The cost of capital for investing in JRN stock is 12%.

a. What is the price of a share of JRN's stock? (Hint: Investors receive after-tax dividend in each year)

b. Assume that management makes a surprise announcement that JRN will no longer pay dividends but will use the cash to repurchase stock instead. What is the price of a share of JRN's stock now?

Answer 1

(a)-Price of a share of JRN's stock

Price of a share of JRN's stock = D1(1 – Tax Rate) / Ke

Current Year Dividend per share (D1) = $3.00 per share

Tax Rate on Dividend = 20%

Required Rate of Return (Ke) = 12%

Therefore, the Price of a share of JRN's stock = D1(1 – Tax Rate) / Ke

= $3.00(1 – 0.20) / 0.12

= [$3.00 x 0.80] / 0.12

= $2.40 / 0.12

= $20.00 per share

(b)-Price of a share of JRN's stock now

Price of a share of JRN's stock = D1 / Ke

= $3.00 / 0.12

= $25.00 per share

NOTE

The tax rate would be 0% in case of repurchase of the stock, therefore, the share price would be same if the dividends were not taxed.