Company Oakland has 100 shares of common stock outstanding. Its current stock pr

Question

Company Oakland has 100 shares of common stock outstanding. Its current stock price is $10 per share. Its current book value is $800 and total debt is $400. The company has $300 of excess cash. Assuming there are no personal income taxes or transaction costs, answer the following questions (i) – (iii).

(i) If the company distributes the excess cash to shareholders as cash dividends, what would be the (a) share price, (b) number of shares outstanding, (c) book value of equity, (d) market value of equity, and (e) debt to equity (market value) ratio before and after the dividend payment? (f) Does debt to equity ratio increase after the dividend payment?

(ii) If the company uses the excess cash to buy back its shares, what would be the (a) share price, (b) number of shares outstanding, (c) book value of equity, (d) market value of equity, and (e) debt to equity (market value) ratio before and after the share repurchase?

(iii) Which distribution policy above ((i) dividends or (ii) share repurchase) would result in greater wealth for shareholders? Provide your answer and briefly discuss the reasoning

Explanation / Answer

a.

Cash Dividend will cause the company's share price to drop by roughly the same amount as the dividend. Thus, the share price will decrease by [300/100] $3 per share. The new share price will be $10 -$3 = $7.

b.

No. of shares outstanding will remain unchanged to 100 shares.

c.

Book Value of Equity = 100 shares x $10 = $1000

d.

Market Value of Equity = 100 shares x $7 = $700

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