5. (20 points) Wallazon (ticker WAZ) is a new firm that specializes in the sale

Question

5. (20 points) Wallazon (ticker WAZ) is a new firm that specializes in the sale of highly profitable walls on-line to generate excess free cash flows to (i) subsidize Wallazon web services, (ii) pay regular dividends, and (iii) do share repurchases. Wallazon pays regular dividends of $1 per share each quarter. The price of Wallazon stock was $40 at the beginning of the year. It is expected to be $45 at the end of the year. a) What is the expected annual rate of return on WAZ stock? b) Why would Wallazon’s Board of Directors also authorize share repurchases instead of simply increasing regular dividends? c) If WAZ stock is expected to grow at the rate calculated in a) indefinitely, how long would it take (in years and partial years) to double, assuming annual compounding? d) Wallazon grows, and its founder Samantha Bezos, becomes the richest person in the world. If Wallazon engaged in positive NPV projects, such as acquiring both Amazon and Walmart in hostile takeovers, how could it go about financing these acquisitions? (Hint: discuss retained earnings, debt issuance, and equity issuance – and payout policy) e) How could Wallazon enhance retained earnings by changing payout policy to help finance acquisitions such as those mentioned in d)? What are the costs and benefits of doing so?

Explanation / Answer

a) Expected annual rate of return = 45-40/40 = 12.5%

b) Share repurchases help in increasing earning per share by decreasing the number of shares issued contrary to dividend issue. This also increases dividend per share and benefits the remaining shareholders.

c) In order to double, the annual rate of return has to be 25%. For this, the price of share has to reach $56.25 from $45. Solving for t in a financial calculator using the formula t = ln(A/P) / ln(1 + r) = [ ln(A) - ln(P) ] / ln(1 + r) or log(A/P) / n[log(1 + r/n)] we get the result as 0.9 years. Therefore, the annual rate of return will double next year.

d) This is discussion part. Please do your own research.

e) Paying dividend is not compulsory especially for a growing company who needs the cash to finance acquisitions. Wallazon can change the frequency of dividend payouts from quarterly to semi-annually or annually. It will also need to cut out dividend per share to generate cash for acquistions. Change of payout policy will not require any additional cost though it will upset the existing shareholders for the time being but this will be beneficial in the long run. The more cash is available for enhancing retained earnings, the less aid of external financing will be required. This means less debt and equity will be required to be issued.

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