Bills Restaurant and Grill is a publicly traded firm. It expects to generate $200 million in operating profit (earnings) in perpetuity with zero net investment. Roughly speaking, this means (Capital expenditures Depreciation) - working capital investments are expected to be zero so earnings exactly equal free cash flow. For simplicity the cash flows arrive at the end of the year. Currently, the firm has no debt and no cash on hand (other than that needed to run the business). We are currently at time zero (start of year 1) and the first cash flow comes at the end of year 1.

The required return on equity is determined by the risk of the earnings/cash flows. Assume the stock beta of this zero debt firm is 1.2, the risk free rate is 4% and the market risk premium is 5%. The CAPM can be used to get the required return on equity

For the following questions we are in a perfect capital market world with no taxes, transaction costs, etc (like the M&M example in class). Assume Bills firm has 100 million shares outstanding.

Notation: P_t = price at time t and E_t = earnings per share (EPS) for year t. (first year is year 1, 2^nd year is year 2, etc

Bill believes in paying dividends to his investors. He intends to pay the entire $200 million of earnings out as a dividend at the end of each year. Assuming no taxes on firms or investors, what would be

the price of the Bills stock at time zero (P₀)

the expected (required) return for year 1

the projected price of Bills stock just before the dividend is paid at the end of year 1

the projected price of Bills stock just after the dividend is paid at the end of year 1 (P₁)

the P₀/E₁ at time 0

Assume the firm decided to go another path. It has decided to pay a special one-time $400m dividend today by issuing $400m of debt with a risk free interest rate and no risk (beta of zero). The borrowing cost is 4% and the debt is perpetual (pays 4% interest on amount borrowed each year forever). The firm will pay out all profit less interest in perpetuity as a dividend at the end of each year.

If Bill follows this dividend and debt strategy, what would be

the price of the Bills stock at time zero before the $400m dividend

the price of Bills stock at time zero after the dividend is paid

the projected price of Bills stock at the end of year 1 just before the dividend is paid at the end of year 1

the projected price of Bills stock just after the dividend is paid at the end of year 1 (P₁)

the projected EPS for year 1 (E₁)

the projected P₀/ E₁ at the end of year one (after dividend paid)

the expected return on the stock for year 1

If the expected return differs from earlier responses in part a) ii)? Explain why?