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VIPSolutions · Accepted Answer

# Objective
We need to analyze a company’s shift from dividend payments to share repurchases and answer three questions:
1. The immediate stock price reaction.
2. The number of shares repurchased.
3. The projected share prices under both policies for 3 years.

---

## Given Data
- **Annual Dividend per Share:** $4.80
- **Shares Outstanding:** 117,000
- **Current Share Price:** $80
- **Company pays out all earnings as dividends (No growth, stable earnings).**
- **Sufficient cash available to pay next dividend ($4.80 per share).**
- **Switch policy from dividend to share repurchases (starting Year 1).**
- **Ignore taxes and assume no info about profitability or risk.**

---

## a. Immediate Stock Price Reaction

### Approach:
- **Dividend Irrelevance Theory** (Miller & Modigliani): Value of the firm is unaffected by dividend policy in a perfect market (no taxes, no transaction costs, no information effect).
- The cash that would have been used for dividends is now used for share repurchase.
- No change in firm value.

### Answer
- The immediate stock price will **remain the same**.

---

## b. How Many Shares Will Be Repurchased?

### Steps:

1. **Total cash available for dividends:**  
   Total Dividends = Dividend per Share × Shares Outstanding  
   Total Dividends = \$4.80 × 117,000 = \$561,600

2. **Number of shares repurchased:**  
   Number of Shares Repurchased = Total Cash Available / Current Share Price  
   Number of Shares Repurchased = \$561,600 / \$80 = 7,020 shares

### Final Calculation:
- Number of shares repurchased = **7,020**

---

## c. Project and Compare Future Stock Prices

### **Old Policy (Dividends)**
#### Under the old policy, the stock price stays at $80 (as no growth, and all earnings are paid out):
- Year 1: \$80
- Year 2: \$80
- Year 3: \$80

### **New Policy (Repurchases)**
#### Shares Outstanding After Repurchase:
- Shares Remaining = 117,000 - 7,020 = 109,980

#### Value per Share:
- The firm’s value remains the same, but fewer shares exist.

#### For Years 1, 2, 3:
- With no growth and all earnings used to repurchase shares each year, the price per share remains the same as before, **\$80** (since share repurchases are just an alternative to dividends, and the payout ratio is 100%).

- **However, if repurchases continue each year:**  
  Each year, the company uses its earnings to buy back more shares at the then-current price, so the price per share remains at \$80, but the number of shares outstanding decreases each year.

| Year | Old Policy | New Policy |
|------|:----------:|:----------:|
| 1    | $80        | $80.00     |
| 2    | $80        | $80.00     |
| 3    | $80        | $80.00     |

---

## Final Answer (Crux)
- **a.** The stock price will **remain the same** immediately after the announcement.
- **b.** The company will **repurchase 7,020 shares**.
- **c.** The projected share prices for both policies over the next three years will remain at **\$80** under both the old and new policy (rounded to whole dollars for old, to two decimals for new policy as required).

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