Suppose company XYZ's free cash flows grow at 5% per year. This growth is not affected by the firm's payout policy. The first free cash flow per share in the next year (year 1) will be $3. The discount rate is 15%. XYZ is considering two potential payout policies. Policy A: Pay out all free cash flows as dividends. The first dividend will be paid in year 1. Questions a) and b) are based on policy A. a) Recall that the share price is the discounted value of all future dividends. What is the share price today? b) What will the cum-dividend and ex-dividend prices be in year 1 and year 2? Policy B: XYZ uses year 1 free cash flow to repurchase shares. After the repurchase, the firm will pay out all future free cash flows as dividends starting from year 2. Questions c) and d) are based on policy B. c) What fraction of total shares can be repurchased in year 1? What is the dividend per share in year 2 and year 3? d) Based on c), what is the ex-dividend price and cum-dividend price in year 2? e) Compare your answers in b) and d). Does your result confirm or contradict Miller-Modigliani dividend policy irrelevance theorem? Why?
Added by Antonio G.
Step 1
The formula is D1 / (r - g), where D1 is the expected dividend in the next year, r is the discount rate, and g is the growth rate. In this case, D1 is $3, r is 15%, and g is 5%. So, the share price today is $3 / (0.15 - 0.05) = $30. Show more…
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