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Dividend Policy Problems

Recall that Miller Modigliani 1961 on dividends says they are not relevant to firm value if the firm's target debt/equity ratio is fixed and investments do not change. What if we change investments or capital structure? Then, dividends could alter firm value to the shareholders.

Assume the Base Case Firm has 100 shares at $20 and the following balance sheet:
Cash $1500 Debt $0 Equity $2000 WACC =10% ( Ke )
Dividends Declared $1000, old cash flow is $200 a year perpetuity.

1)Find the equity beta and the per share dividend payment (assume 1 time annual).

Market info:
Rf = 4% RP = 6% Tax = 34%

Firm is considering an investment that generates an additional cash flow of $300 yearly and costs $1500.

2)Value the firm assuming all cash flows are perpetuities in a perfect market.

Perfect Markets Conditions
Lend and Borrow at same rate, rf. No transactions. No taxes. Same info.

3)Show the value of the firm and per share value for the alternatives below.

Alternatives:
Firm can cancel its dividend and invest in the project.
Firm can pay out its dividend and not invest in the project.
Firm can pay out its dividend and borrow to invest in the project.
Firm can pay out its dividend and sell stock to invest in the project.

In a perfect market, dividends are not taxed and investment doesn't change.

Repeat your analysis for corporate taxes of 34% and a personal tax rate of 20% considering federal and state income taxes.
Summarize your results in a table. Assume the cash flows in the second analysis are still $200 old and $300 additional even though they would really be CF X ( 1 - tax ).

Solution Summary

This in-depth solution contains step-by-step calculations to determine the equity beta, per share divided payment, cash flows, alternatives and firm value for a variety of scenarios.

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