Question:
XYZ Corporation has earnings of $750,000 with 300,000 shares outstanding. Its P/E ratio is 16. The firm is holding $400,000 of funds to invest or pay out in dividends. If the funds are retained, the after-tax return on investment will be 15 percent, and this will add to present earnings. The 15 percent is the normal return anticipated for the corporation and the P/E ratio would remain unchanged. If the funds are paid out in the form of dividends, the P/E ratio will increase by 10 percent because the stockholders are in a very low tax bracket and have a preference for dividends over retained earnings. Which plan will maximize the market value of the stock?