Here are 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
Stock price, y/e 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 All corporate and personal taxes were repealed in 2014.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 be House of Herring’s stock price after the planned dividend payout?
b. Suppose the company 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 company need to repurchase?
c. 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 ex-dividend share prices? How many shares will need to be issued? Again, assume investors learn nothing from the announcement about House of Herring’s prospects.
Respond to the following comment: “It’s all very well saying that I can sell shares to cover cash needs, but that may mean selling at the bottom of the market. If the company pays a regular cash dividend, investors avoid that risk.”
Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market price of $10 a share. It now announces that it intends to issue $160 million of debt and to use the proceeds to buy back common stock.
a. How is the market price of the stock affected by the announcement?
b. How many shares can the company buy back with the $160 million of new debt that it issues? c. What is the market value of the firm (equity plus debt) after the change in capital structure?
d. What is the debt ratio after the change in structure?
e. Who (if anyone) gains or loses?
“MM totally ignore the fact that as you borrow more, you have to pay higher rates of interest.” Explain carefully whether this is a valid objection.