An unlevered firm has a market value of $10 million, with $1 million of its assets in cash. With 500,000 shares outstanding, its current stock price is $20.
a) Under the assumptions of Modigliani-Miller, what is the effect on the stock price of an announcement of a $1 special dividend to be paid in 6 months?
b) Find the new stock price after the ex-dividend date.
c) Assume that firm decides to repurchase $500,000 worth of stock instead. Under the assumptions of Modigliani-Miller, what happens to the share price after the repurchase takes place?
d) Assume now that the personal tax rate exceeds the capital gains tax rate. Will investors prefer the dividend or share repurchase? What happens to the stock price at announcement if the firm decides to pay a special dividend?