2 a given that d1 210 g 71 and p0 35 ke the

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Unformatted text preview: s.) 2. a. Given that D1 = $2.10, g = 7.1%, and P0 = $35, Ke, the expected return to the common stockholder is: $2.10 Ke = + 7.1% $35 = 6% + 7.1% = 13.1% b. If Don’s proposal is adopted, and next year’s dividend is zero, but g rises to 14%, the expected return to the stockholders is: 0 Ke = + 14% $35 = 0 + 14% = 14% It appears that if Montgomery adopted Don Jackson’s suggestion, the stockholders would realize a 0.9% increase in their expected return. By this calculation alone, then, we might conclude that Don’s idea is a good one; the firm should adopt a residual dividend policy. However, note that the stockholders would only realize Don’s 14% gain if they sell their shares, while the firm’s current dividend policy gives the stockholders 13.1%. Given that situation, and the fact that the 1986 Tax Reform Act and subsequent legislation eliminated almost all the advantages of a capital gain at the time of this case, one might well argue that the stockholders are better off under the current policy. Further, note that the stockholders only appear to be better off under the new policy if g does, in fact, rise to 14%, which is speculative at best. If g turns out to be less than 13.1%, for example, the old policy will app...
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This note was uploaded on 12/21/2012 for the course FINC 309 taught by Professor Bunker during the Spring '12 term at Westminster UT.

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