Here are the key financial data for House of Herring, Inc. Earnings per share fo

Question

Here are the key financial data for House of Herring, Inc.

Earnings per share for 2015                  $5.50
Number of shares outstanding              40 million
Target payout ratio                               50%
Planned dividend per share                   $2.75
Stocke price, year-end 2015                  $130
House of Herring plans to pay the entire dividend early in January 2016. All corporate and personal taxes were repealed in 2014.
A. Other things equal, what will the House of Herring's stock price after the planned dividend payout and
Suppose the coompany cancels the dividend and announces that it will use the money saved to repurchase shares. What happens to the stock price on the announcement date? Assume that investors learn nothing about the company's prospects from the announcement. How many shares will the comany need to repurchase? Suppose the company increases dividends to $5.50 per share and then issues new shares to recoup the extra cash paid out as dividends. What happens to the with and ex-dividend share prices? How many shares will need to be issued? Againasusme investors learn nothing from the announcement about House of Herring's prospects.

Explanation / Answer

Part A: On the ex-dividend date, the firm’s stock price drops by the amount of the dividend, so $130 – $2.75 = $127.25. Note: Final exam problems give the earnings per share and payout ratio; you derive the dividend per share. Part B: No cash dividend is paid, so the stock price does not change; it remains $130.00. The cash used to repurchase shares is 50% × $5.50 × 40 million = $110.00 million. Each share costs $130, so the firm repurchases $110 million / $130 = 846,154 shares. Jacob: What difference does it make if the firm pays a dividend or repurchases shares? The firms pays the same amount to shareholders, so the firm’s value after the payment is the same. Why do the share prices differ in these two scenarios? Rachel: If the firm pays a cash dividend, it has 40 million shares outstanding at $127.25 a share, for a total value of $5,090 million. If the firm repurchases 84,615 shares, it has (40 million – 846,154) shares outstanding at $130 a share, for a total value of $5,090 million. Part C: The with-dividend stock price remains $130; the announcement of a larger future dividend doesn’t change the stock price. The ex-dividend stock price is $130 – $5.50 = $124.50. The extra cash paid out is 40 million × $2.75 = $110.00 million. The firm must issue $110 million / $124.50 = 883,534 shares

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