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TBS 907- SPRING 2005 TUTORIAL 6 – DIVIDEND POLICY SOLUTIONS Question 1 The Board of Directors of Smith Ltd. are concerned that their stock might be undervalued in the market. One analyst in Merrill Lynch’s research department commented that the earning per share was low and the cash balance of $800 million was excessive for the company. It was suggested that only $200 million of cash would be sufficient. Your boss, the CFO, called you to her office and asked you to do a comparative study on the merits of special dividends, open market repurchase ( on market), and tender offerings. Your company has 100 million shares of stock outstanding and anticipates $500 million in total earnings this year. The stock is trading at a P/E of 12 based on the expected earnings. a. What is the anticipated EPS this year for the company and what is the current stock price? b. If the company keeps $200 million in cash and pays out $600 million excess cash as a special dividend, what would be the dividend per share and is there any impact on the EPS? What might be the response from the markets and why? c. If the company uses the excess cash to launch an open market repurchase, how many shares will the firm be able to buy back at the current price. What would be the EPS after the buyback? d. If the P/E remains at 12 after the open market repurchase, will the stockholders be better off than receiving a special dividend? Assume that there is no signaling effect. e. To make sure that a tender offer would be successful, companies tend to pay a hefty premium in tender offers. Suppose that this company sends a notice to the stockholders announcing the tender offer price of $75 a share. What is the premium in percentage over the market price and what do you expect an average stockholder to do? f. How many shares will the company be able to buy back with the $600 million excess cash in the tender offer proposed above? What would be the impact on the EPS. g. If the company wants to increase its earnings per share , which alternative should it take. h. If the company wants to send a signal to the markets that its stock is undervalued, which alternative should it take? SOLUTIONS : a. EPS = $5 and price = $60 Calculation: EPS = $500m/100m = $5 Price Per Share = EPS * P/E = $5.00*12 = $60 b. The special dividend per share = $600m/100m = $6 The EPS will remain at $ 5.00 since there is no change in the number of shares outstanding. The market will receive the announcement of the special dividend positively because reducing cash also reduces potential conflict of interest between shareholders and management. c.
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