Dividend Policy and Share-value

ABC's current position

Cash = $2,500
Net Fixed Assets = $8,500

D = Debt = $0
S = Equity = $11,000

Total = $11,000

Total = $11,000

N = Number of Shares outstanding = 1,000

P = Price Per Share = $11,000 / 1,000 = $11.00
V = S + D = $11,000 + $0 = $11,000
It has an investment proposal with:

I = $2,500

PV = $4,000 NPV = $1,500

When ABC announces that it has come up with a +ve NPV investment, its share-price goes up to
$12.50
Cash = $2,500
Net Fixed Assets = $8,500
NPV of New Project = $1,500

D = Debt = $0
S = Equity = $12,500

Total = $12,500

Total = $12,500

How can it use its $2,500 cash?

1)
2)
3)
4)

Invest the $2,500 cash in the new project

Pay out the $2,500 in cash dividends
Retain the $2,500 in firm and pay stock dividends
Use the $2,500 to repurchase shares

Option 1
$2,500 cash would be used up.
Cash = $0
Net Fixed Assets = $11,000
NPV of New Project = $1,500

D = Debt = $0
S = Equity = $12,500

Total = $12,500

Total = $12,500

P remains at $12.50.
Wealth of stockholders remains unchanged at $12.50. W 0= D0 + P0= $0 + $12.50 = $12.50

Option 2
Each existing stockholder would receive $2,500 / 1,000 = $2.50 as there are 1,000 shares. So,
D0 = $2.50.
The Balance Sheet looks as follows thereafter.
Cash = $0
Net Fixed Assets = $8,500
NPV of New Project = $1,500

D = Debt = $0
S = Equity = $10,000

Total = $10,000

Total = $10,000

P0 = $10,000 / 1,000 = $10.00 =>

W0 = D0 + P0 = $2.50 + $10.00 = $12.50 => Shareholders' wealth is unchanged.
ABC would need to raise $2,500 for investing in the project. It would issue N iss new shares at Piss,
so that
Niss x Piss = $2,500.
New shareholders know that, after the issue, there will be N + N iss shares outstanding and the
Balance Sheet would look as follows.
Cash = $2,500 (new capital raised)
Net Fixed Assets = $8,500
NPV of New Project = $1,500

D = Debt = $0
S = Equity = $12,500

Total = $12,500

Total = $12,500

So, for each share,

VAI (Value After Issue) = $12,500 / [N + Niss] = $12,500 / [1000 + Niss]
Moreover, fair-pricing would ensure that the issue-price is equal to the value of each share after
the issue:
Piss = VAI
If Piss is greater, the new shareholders would have been fooled, while, if it is less, the new
shareholders would have gained at the expense of the existing shareholders ("wealth transfer"
from existing shareholders to new shareholders).
It is easy to check that, in this scenario, the issue-price should be the prevailing market-price.
Piss = $12,500 / [1000 + Niss] => Piss x [1000 + Niss] = 12,500
=> 1000 Piss + (Niss x Piss) = 12,500
=> 1000 Piss + 2,500 = 12,500 => Piss = 10
And, therefore, Niss = 2,500 / 10 = 250.
So, there would be 1,250 shares outstanding after the issue, with each share valued at $10. The
wealth of the existing shareholders would, therefore, not be affected.
2

Option 3
If the $2,500 is retained in the firm, the wealth of the stockholders remains unchanged at
$12.50.
Cash = $2,500
Net Fixed Assets = $8,500
NPV of New Project = $1,500

D = Debt = $0
S = Equity = $12,500

Total = $12,500

Total = $12,500

Now, if the firm pays a stock dividend by issuing N iss shares to the existing shareholders, their
wealth still remains unchanged. To see this let us assume = 250, that is, the firm issues 25%
stock-dividend, 1 free new share for each 4 shares held. Then, there would be 1250 shares
outstanding after the dividend-payment, but, since no new capital has been generated, we get
that
P = 12,500 / 1,250 = $10
But, since each old shareholder has now 1.25 shares, her shares are worth 1.25 x $10 = $12.50,
thus keeping her wealth unchanged.
Option 4
What if $2,500 is used to repurchase shares? It is easy to see that, if ABC repurchases N rep
shares, then the Repurchase-Price (RP) must be so set that
RP x Nrep = $2,500 => RP = 2,500 / Nrep
When the repurchase offer is announced, some shareholders would tender their shares against
the offer, while others would not tender (and stick to their shares). To ensure that those
tendering are not better off or worse off than those not tendering, we need that the RP equal the
Price After Repurchase (PAR)
RP = PAR
But, we know that the Balance Sheet after the repurchase would as follows
Cash = $0
Net Fixed Assets = $8,500
NPV of New Project = $1,500

D = Debt = $0
S = Equity = $10,000

Total = $10,000

Total = $10,000

So, PAR = 10,000 / [N - Nrep] = 10,000 / [1,000 - Nrep]

Therefore, RP = PAR condition implies that
2,500 / Nrep= 10,000 / [1,000 - Nrep] => Nrep = 200 and, therefore, RP = PAR = 2,500 / 200 =
12.50
Thus 1,000 - 200 = 800 shares would be outstanding after the repurchase, each with a shareprice of $12.50. So, independent of whether she tenders or not, the wealth of an old shareholder
would remain unchanged at $12.50. To raise $2,500 required for investment, 200 shares may be
3

issued at the market-price of $12.50, thus pushing up the number of shares to 1,000, each
valued at $12.50. Back to square one.

What happens when ABC goes for a debt-financed re-purchase, that is, suppose ABC invests the
$2,500 in the project and then go for a debt-financed repurchase of shares. As we saw under
Option-1, after investing the $2,500 in the project, the shareholder's wealth remains at $12.50.
At this point, suppose that ABC plans to go for share-repurchase, financed by debt-issuance.
Let us take the corporate tax-rate as 40%. As we know, since interest-payments are taxdeductible, for each $1 debt, ABC's share-value would go up by the PVITS (PV of Interest Tax
Shield) of $0.40 (= $1 x 40%). Thus, for each $10,000 loan, ABC's share-price would rise by
$4000 / 1,000 = $4.00, as soon as the announcement regarding the proposed debt-issue is
made, and the shares can be bought back only at this post-announcement price. For example, if
the firm announces plan to go for a share-repurchase financed by new debt of $2,500, the share
price would zoom to $13.50, as $2,500 debt would engender PVITS of $1,000 or $1 per share. In
that case, the new debt of $2,500 would be able to buy-back 185 shares, leaving 815 shares
outstanding afterwards, with a per-share-price of $13.50 and a total market-value of $11,000.