Consider an all-equity financed Chinese firm Tentent Ltd. Due to its past investments, the firm will generate net cash flows of 5M now (t=0) and 10M next year (t=1). The expected return on the equity is 12.8%. Tentent Ltd. has an NPV opportunity that costs 1M now and generates cash flows worth 2M next year. There is no more cash flows whatsoever for the firm after next year.

(a) Suppose Tentent Ltd. has the policy to invest in positive NPV projects and distribute the remaining earnings as dividends to shareholders. What is the dividend Tentent Ltd. pays now and the dividend it pays next year, assuming that it does not raise any additional funds?

b), What is the total equity value of Tentent Ltd. before the first dividend payment date? What is the total equity value of Tentent Ltd. just after the ex-dividend date for the first dividend payment?

c) Suppose Tentent Ltd. has the policy to invest in positive NPV projects and use the remaining earnings to repurchase shares now (t=0). If Tentent Ltd. has 1 million shares outstanding, what is the share price before the share repurchase? How many shares (a whole number, that is, an integer) will it repurchase if shares are repurchased at the market price? What is value of shares after the repurchase?

d) An investor has a personal income tax rate of 25% and a capital gains tax rate of 40%. Explain which of two payout policy methods will the investor prefer Tentent Ltd. to follow?

e) What does Jensen (1986) suggest about the impact of dividends on the agency costs of Free Cash Flow?