IMB has 1 million outstanding shares, currently trading at $10 each, and it is all-equity financed. Current earnings are $2 million, which also provide the company's current cash holdings. At the next board meeting, the directors will be discussing whether to implement a new investment project, not yet known to the public. The project costs $1 million and it will generate expected earnings of $.5 million a year, in perpetuity starting one year from now. The appropriate discount rate for the project is 10%.

If the project is not undertaken, the firm will pay a dividend of $2 a share. If the project is implemented, the firm must decide how to finance it. The board is considering two options: i) to finance the investment project by retaining earnings and paying only $1 dividend per share; ii) to keep the dividend at $2 per share, and to finance the project by issuing new equity. Shares are issued ex-dividend. Capital markets are perfect (no taxes).

a) Should the firm take the project?

If the answer to (a) is yes, answer the following:

b) What will the cum-dividend stock price be, after the announcement of the implementation of the project and its financing with retained earnings? What will the ex-dividend price be?

c) What will the cum-dividend stock price be, if instead the firm announces the financing of the project by a simultaneous new equity issue? What is the ex-dividend price now, and how many share must the firm issue?

d) Briefly discuss the effect of these decisions on original stockholders' wealth.