You own 100 shares in the firm Alfa. The current share price is £10 and the earnings per share is £0.70. Assume there are no capital market imperfections and that Alfa’s annual earnings will remain constant in future. Alfa pays out all of its earnings each year as dividends. You prefer to invest your money in the firm, so you reinvest each year’s dividend in the firm by buying more of its shares. Your investment horizon is 10 years.

i. What is the value of your investment after 10 years? What would the value of your investment have been, if Alfa’s policy was a zero dividend payout over the same period?

ii. Assume now that there are personal taxes but no other market imperfections. The tax rate on both dividends and capital gains is 30%.

iii. Assume again that Alfa pays out all its earnings as dividends. You reinvest all your dividends back in the firm but decide to sell your shares at your 10 year investment horizon, immediately after the last dividend was paid. What is the value of your wealth?

iv. What would be your answer in (ii), assuming now that Alfa’s policy was a zero dividend payout over the 10 years? Is it different? Why/why not?