You have become the new CEO of Y & Associates. The last CEO did some thinking on borrowing, but left you with no advice on dividend policy. You want to know what happens to your stock price as a result of returning money to investors. You know the following:

i) You are planning to declare a dividend of $0.40, on which investors face a tax rate of 35%;

ii) Investors pay a capital gains tax of 35%, which can be deferred to future years;

iii) Investors have an opportunity cost of 8.5% in evaluating future cash flows.

(a) If the price of one share of Y&A (before the ex-dividend date) is $27, assuming the average investor defers taxes for 4

years, what will the price be right after the ex-dividend day?

(b) Assume now that the majority of your investors are corporations who face a capital gains tax of 35% and a 42.5%

ordinary tax on income (including dividends). Also assume now that, instead of being able to defer taxes, investors are

allowed to exempt 65% of the dividends they receive from taxes. If the shares are selling at $27 each, how much will the

stock price drop by by the end of the ex-dividend day?

(c) Explain intuitively why the price of the stock changes on the ex-dividend day.