17-9. Suppose you work for Oracle Corporation, and part of your compensation takes the form of stock options. The value of the stock option is equal to the difference between Oracle’s stock price and an exercise price of $10 per share at the time that you exercise the option. As an option holder, would you prefer that Oracle use dividends or share repurchases to pay out cash to shareholders? Explain.
17-10. The HNH Corporation will pay a constant dividend of $2 per share, per year, in perpetuity. Assume all investors pay a 20% tax on dividends and that there is no capital gains tax. Suppose that other investments with equivalent risk to HNH stock offer an after-tax return of 12%.
a. What is the price of a share of HNH stock?
b. Assume that management makes a surprise announcement that HNH will no longer pay dividends but will use the cash to repurchase stock instead. What is the price of a share of HNH stock now?
17-11. Using Table 17.2, for each of the following years, state whether dividends were tax disadvantaged or not for individual investors with a one-year investment horizon:
17-12. What was the effective dividend tax rate for a U.S. investor in the highest tax bracket who planned to hold a stock for one year in 1981? How did the effective dividend tax rate change in 1982 when the Reagan tax cuts took effect? (Ignore state taxes.)
17-13. The dividend tax cut passed in 2003 lowered the effective dividend tax rate for a U.S. investor in the highest tax bracket to a historic low. During which other periods in the last 35 years was the effective dividend tax rate as low?
17-14. Suppose that all capital gains are taxed at a 25% rate, and that the dividend tax rate is 50%. Arbuckle Corp. is currently trading for $30, and is about to pay a $6 special dividend.
a. Absent any other trading frictions or news, what will its share price be just after the dividend is paid?
Suppose Arbuckle made a surprise announcement that it would do a share repurchase rather than pay a special dividend.
b. What net tax savings per share for an investor would result from this decision?
c. What would happen to Arbuckle’s stock price upon the announcement of this change?
17-15. You purchased CSH stock for $40 one year ago and it is now selling for $50. The company has announced that it plans a $10 special dividend. You are considering whether to sell the stock now, or wait to receive the dividend and then sell.
a. Assuming 2008 tax rates, what ex-dividend price of CSH will make you indifferent between selling now and waiting?
b. Suppose the capital gains tax rate is 20% and the dividend tax rate is 40%, what ex-dividend price would make you indifferent now?
17-16. On Monday, November 15, 2004, TheStreet.com reported: “An experiment in the efficiency of financial markets will play out Monday following the expiration of a $3.08 dividend privilege for holders of Microsoft.” The story went on: “The stock is currently trading ex-dividend both the special $3 payout and Microsoft’s regular $0.08 quarterly dividend, meaning a buyer doesn’t receive the money if he acquires the shares now.” Microsoft stock ultimately opened for trade at $27.34 on the ex-dividend date (November 15), down $2.63 from its previous close.
a. Assuming that this price drop resulted only from the dividend payment (no other information affected the stock price that day), what does this decline in price imply about the effective dividend tax rate for Microsoft?
b. Based on this information, which of the following investors are most likely to be the marginal investors (the ones who determine the price) in Microsoft stock:
i. Long-term individual investors?
ii. One-year individual investors?
iii. Pension funds?
17-17. At current tax rates, which of the following investors are most likely to hold a stock that has a high dividend yield:
a. Individual investors?
b. Pension funds?
c. Mutual funds?
17-18. Que Corporation pays a regular dividend of $1 per share. Typically, the stock price drops by $0.80 per share when the stock goes ex-dividend. Suppose the capital gains tax rate is 20%, but investors pay different tax rates on dividends. Absent transactions costs, what is the highest dividend tax rate of an investor who could gain from trading to capture the dividend?
17-19. A stock that you know is held by long-term individual investors paid a large one-time dividend. You notice that the price drop on the ex-dividend date is about the size of the dividend payment. You find this relationship puzzling given the tax disadvantage of dividends. Explain how the dividend-capture theory might account for this behavior.
17-20. Clovix Corporation has $50 million in cash, 10 million shares outstanding, and a current share price of $30. Clovix is deciding whether to use the $50 million to pay an immediate special dividend of $5 per share, or to retain and invest it at the risk-free rate of 10% and use the $5 million in interest earned to increase its regular annual dividend of $0.50 per share. Assume perfect capital markets.
a. Suppose Clovix pays the special dividend. How can a shareholder who would prefer an increase in the regular dividend create it on her own?
b. Suppose Clovix increases its regular dividend. How can a shareholder who would prefer the special dividend create it on her own?
17-21. Assume capital markets are perfect. Kay Industries currently has $100 million invested in short term Treasury securities paying 7%, and it pays out the interest payments on these securities each year as a dividend. The board is considering selling the Treasury securities and paying out the proceeds as a one-time dividend payment.
a. If the board went ahead with this plan, what would happen to the value of Kay stock upon the announcement of a change in policy?
b. What would happen to the value of Kay stock on the ex-dividend date of the one-time dividend?
c. Given these price reactions, will this decision benefit investors?
17-22. Redo Problem 21, but assume that Kay must pay a corporate tax rate of 35%, and investors pay no taxes.
17-23. Harris Corporation has $250 million in cash, and 100 million shares outstanding. Suppose the corporate tax rate is 35%, and investors pay no taxes on dividends, capital gains, or interest income. Investors had expected Harris to pay out the $250 million through a share repurchase. Suppose instead that Harris announces it will permanently retain the cash, and use the interest on the cash to pay a regular dividend. If there are no other benefits of retaining the cash, how will Harris’ stock price change upon this announcement?
17-24. Redo Problem 21, but assume the following:
a. Investors pay a 15% tax on dividends but no capital gains taxes or taxes on interest income, and Kay does not pay corporate taxes.
b. Investors pay a 15% tax on dividends and capital gains, and a 35% tax on interest income, while Kay pays a 35% corporate tax rate.
17-25. Raviv Industries has $100 million in cash that it can use for a share repurchase. Suppose instead Raviv invests the funds in an account paying 10% interest for one year.
a. If the corporate tax rate is 40%, how much additional cash will Raviv have at the end of the year net of corporate taxes?
b. If investors pay a 20% tax rate on capital gains, by how much will the value of their shares have increased, net of capital gains taxes?
c. If investors pay a 30% tax rate on interest income, how much would they have had if they invested the $100 million on their own?
d. Suppose Raviv retained the cash so that it would not need to raise new funds from outside investors for an expansion it has planned for next year. If it did raise new funds, it would have to pay issuance fees. How much does Raviv need to save in issuance fees to make retaining the cash beneficial for its investors? (Assume fees can be expensed for corporate tax purposes.)
17-26. Use the data in Table 15.3 to calculate the tax disadvantage of retained cash in the following:
17-27. Explain under which conditions an increase in the dividend payment can be interpreted as a signal of the following:
a. Good news
b. Bad news
17-28. Why is an announcement of a share repurchase considered a positive signal?
17-29. AMC Corporation currently has an enterprise value of $400 million and $100 million in excess cash. The firm has 10 million shares outstanding and no debt. Suppose AMC uses its excess cash to repurchase shares. After the share repurchase, news will come out that will change AMC’s enterprise value to either $600 million or $200 million.
a. What is AMC’s share price prior to the share repurchase?
b. What is AMC’s share price after the repurchase if its enterprise value goes up? What is AMC’s share price after the repurchase if its enterprise value declines?
c. Suppose AMC waits until after the news comes out to do the share repurchase. What is AMC’s share price after the repurchase if its enterprise value goes up? What is AMC’s share price after the repurchase if its enterprise value declines?
d. Suppose AMC management expects good news to come out. Based on your answers to parts (b) and (c), if management desires to maximize AMC’s ultimate share price, will they undertake the repurchase before or after the news comes out? When would management undertake the repurchase if they expect bad news to come out?
e. Given your answer to part (d), what effect would you expect an announcement of a share repurchase to have on the stock price? Why?
17-30. Berkshire Hathaway’s A shares are trading at $120,000. What split ratio would it need to bring its stock price down to $50?
17-31. Suppose the stock of Host Hotels & Resorts is currently trading for $20 per share.
a. If Host issued a 20% stock dividend, what will its new share price be?
b. If Host does a 3:2 stock split, what will its new share price be?
c. If Host does a 1:3 reverse split, what will its new share price be?
17-32. Explain why most companies choose to pay stock dividends (split their stock).
17-33. When might it be advantageous to undertake a reverse stock split?
17-34. After the market close on May 11, 2001, Adaptec, Inc., distributed a dividend of shares of the stock of its software division, Roxio, Inc. Each Adaptec shareholder received 0.1646 share of Roxio stock per share of Adaptec stock owned. At the time, Adaptec stock was trading at a price of $10.55 per share (cum-dividend), and Roxio’s share price was $14.23 per share. In a perfect market, what would Adaptec’s ex-dividend share price be after this transaction?
Lecture Six - Valuing Bonds
8-1. A 30-year bond with a face value of $1000 has a coupon rate of 5.5%, with semiannual payments.
a. What is the coupon payment for this bond?
b. Draw the cash flows for the bond on a timeline.
8-2. Assume that a bond will make payments every six months as shown on the following timeline (using six-month periods):
a. What is the maturity of the bond (in years)?
b. What is the coupon rate (in percent)?
c. What is the face value?
8-3. The following table summarizes prices of various default-free, zero-coupon bonds (expressed as a percentage of face value):
a. Compute the yield to maturity for each bond.
b. Plot the zero-coupon yield curve (for the first five years).
c. Is the yield curve upward sloping, downward sloping, or flat?
8-4. Suppose the current zero-coupon yield curve for risk-free bonds is as follows:
a. What is the price per $100 face value of a two-year, zero-coupon, risk-free bond?
b. What is the price per $100 face value of a four-year, zero-coupon, risk-free bond?
c. What is the risk-free interest rate for a five-year maturity?
8-5. In the box in Section 8.1, Bloomberg.com reported that the three-month Treasury bill sold for a price of $100.002556 per $100 face value. What is the yield to maturity of this bond, expressed as an EAR?
8-6. Suppose a 10-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading for a price of $1034.74.
a. What is the bond’s yield to maturity (expressed as an APR with semiannual compounding)?
b. If the bond’s yield to maturity changes to 9% APR, what will the bond’s price be?
8-7. Suppose a five-year, $1000 bond with annual coupons has a price of $900 and a yield to maturity of 6%. What is the bond’s coupon rate?
8-8. The prices of several bonds with face values of $1000 are summarized in the following table:
For each bond, state whether it trades at a discount, at par, or at a premium.
Bond A trades at a discount. Bond D trades at par. Bonds B and C trade at a premium.
8-9. Explain why the yield of a bond that trades at a discount exceeds the bond’s coupon rate.
8-10. Suppose a seven-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading with a yield to maturity of 6.75%.
a. Is this bond currently trading at a discount, at par, or at a premium? Explain.
b. If the yield to maturity of the bond rises to 7% (APR with semiannual compounding), what price will the bond trade for?
8-11. Suppose that General Motors Acceptance Corporation issued a bond with 10 years until maturity, a face value of $1000, and a coupon rate of 7% (annual payments). The yield to maturity on this bond when it was issued was 6%.
a. What was the price of this bond when it was issued?
b. Assuming the yield to maturity remains constant, what is the price of the bond immediately before it makes its first coupon payment?
c. Assuming the yield to maturity remains constant, what is the price of the bond immediately after it makes its first coupon payment?
8-12. Suppose you purchase a 10-year bond with 6% annual coupons. You hold the bond for four years, and sell it immediately after receiving the fourth coupon. If the bond’s yield to maturity was 5% when you purchased and sold the bond,
a. What cash flows will you pay and receive from your investment in the bond per $100 face value?
b. What is the internal rate of return of your investment?
8-13. Consider the following bonds:
a. What is the percentage change in the price of each bond if its yield to maturity falls from 6% to 5%?
b. Which of the bonds A–D is most sensitive to a 1% drop in interest rates from 6% to 5% and why? Which bond is least sensitive? Provide an intuitive explanation for your answer.
8-14. Suppose you purchase a 30-year, zero-coupon bond with a yield to maturity of 6%. You hold the bond for five years before selling it.
a. If the bond’s yield to maturity is 6% when you sell it, what is the internal rate of return of your investment?
b. If the bond’s yield to maturity is 7% when you sell it, what is the internal rate of return of your investment?
c. If the bond’s yield to maturity is 5% when you sell it, what is the internal rate of return of your investment?
d. Even if a bond has no chance of default, is your investment risk free if you plan to sell it before it matures? Explain.