Question
Company X has one million outstanding shares with a total market value of $20 million. The rm is expected to pay $1 million of dividends
Company X has one million outstanding shares with a total market value of $20 million. The rm is expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected to grow by 5% a year in perpetuity. Thus the expected dividend is $1.05 million in year 2, $1.1025 million in year 3, and so on. However, the company has heard that the value of a share depends on the flow of dividends, and therefore it announces that next year's dividend will be increased to $2 million and that the extra cash will be raised immediately afterward by an issue of shares. After that, the total amount paid out each year will be as previously forecast, that is $1.05 and increasing by 5% in each subsequent year. At what price will the new shares be issued in year 1? How many shares will the firm need to issue? What will the expected dividend payments be on these new shares, and what therefore will be paid out to the old share-holders after year 1? Show that the present value of the cash flows to current share-holders remains $20 million.
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