Good
Values, Inc., is all-equity-financed. The total market value of the firm
currently is $240,000, and there are 3,000 shares outstanding. Good Values
plans to repurchase $24,000 worth of stock. Ignore taxes.
|
a.
|
What will be the stock price
before and after the repurchase?
|
Stock
Price
|
|
Before
|
$
per
share
|
After
|
per
share
|
Explanation:
a.
|
The repurchase will have no tax
implications. Because the repurchase does not create a tax obligation for the
shareholders, the value of the firm today is the value of the firm’s assets
($240,000) divided by 3,000 shares, or $80 per share. The firm will
repurchase 300 shares for $24,000. After the repurchase, the stock will
sell at a price of $216,000/2,700 = $80 per share.
|
The price is the same as before
the repurchase.
|
Investors
require an after-tax rate of return of 10% on their stock investments. Assume
that the tax rate on dividends is 30% while capital gains escape taxation. A
firm will pay a $1 per share dividend 1 year from now, after which it is
expected to sell at a price of $10.
|
a.
|
Find
the current price of the stock. (Do not round
intermediate calculations. Round your answer to 2 decimal places.)
|
Current price
|
$
|
b.
|
Find
the expected before-tax rate of return for a 1-year holding period. (Do not round intermediate calculations. Round your answers
to 2 decimal places.)
|
Before-tax rate of
return
|
%
|
c.
|
Now
suppose that the dividend will be $2 per share. If the expected after-tax
rate of return is still 10%, and investors still expect the stock to sell at
$10 in 1 year, at what price must the stock now sell? (Do not round intermediate calculations. Round your answer
to 2 decimal places.)
|
Price
|
$
|
d-1.
|
What
is the before-tax rate of return? (Do not round
intermediate calculations. Round your answer to 2 decimal places.)
|
Before-tax rate of
return
|
%
|
d-2.
|
Why is it now higher than in part
(b)?
|
The before-tax return
is higher because the larger dividend creates a
greater tax burden. |
Explanation:
Some values below may show as
rounded for display purposes, though unrounded numbers should be used for the
actual calculations.
|
a.
Price
= PV (after-tax dividend plus final share price) =
|
[$1 × (1 − 0.30)] + $10
|
= $9.73
|
1.10
|
b.
Before-tax
rate of return =
|
dividend + capital gain
|
=
|
$1.00 + ($10.00 − $9.73)
|
= 0.1308 = 13.08%
|
price
|
$9.73
|
c.
Price
= PV (after-tax dividend plus final share price) =
|
[$2 × (1 − 0.30)] + $10
|
= $10.36
|
1.10
|
d-1.
Before-tax
rate of return =
|
dividend + capital gain
|
=
|
$2 + ($10 − $10.36)
|
= 0.1579 = 15.79%
|
price
|
$10.36
|
d-2.
The
before-tax return must increase in order to provide the same after-tax return
of 10%.
|
