Metro is an all-equity firm with 1 million shares outstanding and its cost of equity is 10%. The firm will be liquidated at t=2. The total earnings including the proceeds from liquidation, are $50 million in each of the next two years. There are no taxes, transaction costs, or other market imperfections. The firm has the following two dividend policies options.
(1) Pay all earnings in dividends for each of the two years.
(2) Pay out 80% of earnings in the first year, retain and reinvest the remaining 20% of earnings in the firm at 10% and pay out all available earnings in the second year.
1. Suppose the firm chooses Policy 1, but an investor, who owns 100 shares, prefers Policy 2. What could she do to replicate her preferred dividend policy and how much would she receive in dividends at t=2 following this strategy?
2. Suppose the firm chooses Policy 2, but an investor, who owns 100 shares, prefers Policy 1. What could he do to replicate his preferred dividend policy and how much would he receive in dividends at t=2 following this strategy?