Star Company has outstanding 2 million shares with a total market value of $20 million. The firm is expected to pay $2 million of dividends next year, and thereafter the amount paid out is expected to grow by 6% a year in perpetuity. Thus, the expected dividend is $2.12 million in year 2, $2.2472 million in year 3, and so on. Now the company announces that next years dividend will be increased to $3 million and that the extra cash will be raised by an issue of shares next year. After that, the total amount paid out each year will be as previously forecasted, that is, $2.12 million in year 2 and increasing by 6% in each subsequent year.

a. At what (ex-dividend) price will the new shares be issued in year 1? How many shares will the firm need to issue? What is the % ownership of old shareholders after the issue?

b. In year 2, what will be the expected dividend payments to new shareholders, and what will be paid out to the old shareholders?

c. Show that the present value of future cash flows to current shareholders remains $20 million.

d. Suppose that the new shares are issued in year 1 at $15 per share. Who gains and who loses? Is dividend policy still irrelevant?

Suppose the company decides to repurchase shares instead of paying out $2 million cash dividends next year. After that, the total amount paid out each year will still be as previously forecasted, that is, $2.12 million in year 2 and increasing by 6% in each subsequent year.

e. At what price will the company repurchase shares next year? How many shares will be repurchased?

f. After the payout, what is the percentage ownership of an investor who holds 1% of the shares before the payout and does not sell shares during the repurchase?

g. What is the present value of all future dividends to this investor?