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Little Oil has outstanding one million shares with a total market value of $20 million. The firm is expected to pay $1 million of dividends

Little Oil has outstanding one million shares with a total market value of $20 million. The

firm 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, $1.105 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 by an issue of shares. After that, the total amount paid out each year will be as

previously forecasted, that is, $1.05 million in year 2 and increasing by 5% in each

subsequent year.

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