Payout Policy

Suppose company XYZ's free cash flows grow at 5% per year. This growth is not affected by the

firm's payout policy. The first free cash flow per share in the next year (year 1) will be $3. The

discount rate is 15%. XYZ is considering two potential payout policies.

Policy A:

Pay out all free cash flows as dividend. The first dividend will be paid in year 1.

Questions a) and b) are based on policy A.

a) Recall that share price is the discounted value of all future dividends. What is the share price

today?

b) What will the cum-dividend and ex-dividend price be in year 1 and year 2?

Policy B:

XYZ uses year 1 free cash flow to repurchase shares. After the repurchase, the firm will

pay out all future free cash flows as dividends starting from year 2. Questions c) and d) are based

on policy B.

c) What fraction of total shares can be repurchased in year 1? What is the dividend per share in

year 2 and year 3?

d) Based on c), what is the ex-dividend price and cum-dividend price in year 2?

e) Compare your answers in b) and d), does your result confirm or contradict Miller-Modigliani

dividend policy irrelevance theorem? Why?