Johnson Trucking has cash available of $25 million, out of which a portion is to be paid out as dividend, with the remaining re-invested in the firm.
It is deciding whether to pay out $10 million (option 1), $15 million (option 2) or $20 million (option 3) in dividends (re-investing the remaining cash in each case in the firm).
Since the equity market is characterized by asymmetric information about the firm's future cash flows, higher dividend will increase the firm's current cash flows, but will reduce the firm's intrinsic (long term) value (because increased dividends leads to lower investment in this case).
The following table gives the firm's intrinsic value and current market value for each of the three alternative levels of dividends being considered:
Option I Option II Option III
Dividend $10 mil $15 mil $20 mil
Re-invested $15 mil $10 mil $ 5 mil
Intrinsic value $220 mil $210 mil $200 mil
Market value $190 mil $210 mil $215 mil
If management is indifferent to current market value of the firm's equity, which option will they choose?
If management cares about current market value as well as the intrinsic (long-term) value of the equity, such that they want to maximize an equally weighted average of the firm's current value and market value, which option will they choose?