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FIN 320 - Managerial Finance Problem Set 3 Due: October 2, 2015 Question 1 It is January 1, 1998 and you plan to buy 1,000 shares in Company DVS and hold them for exactly one year. According to the CAPM, the expected return on DVS equity is 10 percent (pre-personal tax). The current price per share is $20. For now, assume no taxes. a) DVS will pay a dividend of $1.50 per share on December 31, 1998. What is your total dividend income and expected capital gains income when you sell your shares on January 1, 1999? Keep in mind that the expected share price will appreciate by 10 percent, and then drop by the dividend per share. b) Company CGS is identical to DVS except that it will pay no dividend in the following year. Are you better off purchasing 1,000 shares in Company CGS instead and selling them one year later? Now assume a dividend tax rate of 40% and a capital gains tax rate of 20%. c) What is the ex-dividend price per share of DVS on January 1, 1999? d) What is your total dividend income and expected capital gains income in DVS (after-tax)? How does it compare to the case in which you buy 1,000 shares in CGS instead? Question 2 On January 30, 2015, Costco Wholesale Corporation (symbol: COST) announced that it would pay a special dividend of $5.00 per share on February 5, 2015 for a total payment of approximately $2.2 billion. That is, if you hold this stock at the beginning of February 5, 2015 (the ex-dividend date), then you will be paid a dividend of $5 per share. Otherwise, you do not receive the dividend. The purpose of this question is to examine the price reaction on the announcement date and ex-dividend date. a) Download daily price data for COST from Yahoo! Finance for the period January 2, 2015 to February 27, 2015. Sort the data so that the date is in ascending order. Graph the price series (use closing price, not adjusted closing price) and highlight the day the special dividend was announced and the ex-dividend day. b) In a frictionless environment, what should be the price reaction on the announcement date? What should be the price reaction on the ex-dividend date? c) What is the change in price from the close of the announcement day (the closing price on Friday) to the open of the following business day (the opening price on Monday)? If this is different from your answer in part (b), provide a possible explanation for the difference. d) What is the change in price from the close of the day preceding the ex-dividend day to the open of the ex-dividend day? Calculate the effective dividend tax rate implied by this price change and the dividend per share. e) The top marginal tax rates in 2015 for both dividends and capital gains are 20 percent, which implies an effective dividend tax rate of zero. Why do you think this is different from your answer in part (d)? (this difference is most likely related to reasons other than taxes) Question 3 You currently operate a factory that produces 1M widgets per year. The cost of producing each widget will always be $20. For the next five years, widgets will sell for $30. Following that, the selling price per widget will permanently be either $10 (30% probability), $30 (40% probability), or $50 (30% probability). For now, assume no real options to stop or expand production. Assume a discount rate of 12.5 percent. a) What is the present value of future expected cash flows from this factory? Now assume that you learn at t=5 what the widget selling price will be from t=6 onward. b) Suppose that you have the real option to abandon the factory and incur a demolition cost of $10M at t=5. In which states will you exercise the option to abandon the factory? Explain. c) Also suppose that you have the real option to increase factory production by 20 percent at t=5. This would involve a one-time cost of $25M at t=5. In which states would you exercise the option to expand production at t=5? Explain. d) What is the present value of future expected cash flows from this factory at t=0, given that you have the abandonment option and the option to expand production by 20 percent at t=5? Question 4 Your all-equity firm consists of a factory that will generate $75M per year in perpetual free cash flows starting at t=0. Assume that all free cash flows go to stockholders. Analysis of comparable firms tells you that your expected return on assets is 10 percent (which is the same as the expected return on equity since this is an all-equity firm). Assume that there are 10M shares outstanding. a) What is the price per share for this firm just before and just after the dividend is paid out at t=0? b) The firm is considering a share repurchase of $75M at t=0 instead. How many shares would the firm repurchase? What would be the share price after the firm repurchases the shares at t=0? Suppose that your firm would like to issue $125M worth of dividends at t=0, thus needing an additional $50M. The firm plans to issue $50M worth of shares today (t=0) so that it can pay out a $125M dividend at t=0. c) What percentage of the firm do you have to sell to raise $50M at t=0? d) What is the price per share for this firm just before the dividend is paid out, but following the issuance of new shares, at t=0? e) What is the price per share for this firm immediately following the dividend payout at t=0