Textbook Problem

ALTERNATIVE DIVIDEND POLICIES Rubenstein Bros. Clothing is expecting to pay an annual dividend per share of $0.75 out of annual earnings per share of $225. Currently. Rubenstein Bros stock is selling for $12.50 per share. Adhering to the company’s target capital structure, the firm has $10 million in total invested capital, of which 40% is funded by debt. Assume that the firm’s book value of equity equals its market value. In past years, the firm has earned a return on equity (ROE) of 18%, which is expected to continue this year and into the foreseeable future.

1. a. Based on this information, what long-run growth rate can the firm be expected to maintain? (Hint: g = Retention rate × ROE.)
2. b. What is the stock’s required return?
3. c. If the firm changed its dividend policy and paid an annual dividend of $1.50 per share, financial analysts would predict that the change in policy will have no effect on the firm’s stock price or ROE. Therefore, what must be the firm’s new exported long-run growth rate and required return?
4. d. Suppose instead that the firm has decided to proceed with its original plan of disbursing 50.75 per share to shareholders, but the firm intends to do so in the form of a stock dividend rather than a cash dividend. The firm will allot new shares based on the current stock price of $12.50. In other words, for every $1250 in dividends due to shareholders, a share of stock will be issued. How large will the stock dividend be relative to the firm’s current market capitalization? (Hint: Remember that market capitalization = P₀ × number of sharers outstanding.)
5. e. If the plan in part d is implemented, how many new shares of stock will be issued, and by how much will the company’s earnings per share be diluted?