Company XYZ has found itself with $5 million of unneeded cash, and the firm’s president has indicated that he will suggest the board of directors declare an “extra” dividend of $5 per share on the million shares outstanding. The current stock price is $45 per share and current annual earnings are about $8 per share (excluding interest income on the $5 million held currently in the form of a certificate of deposit).

The market price of $45 appears to be comprised of a basic P/E ratio of 5 on the current earnings plus the anticipated extra $5 million to repurchase stock.

The firm’s investment banker indicates that a purchase price of $50 per share on a tender offer would be sufficient to attract 100,000 shares for repurchase.

Assume that the P/E ratio that would be adopted by the market after the reacquisition is again 5. Assume a zero-tax, zero-transaction-cost world.

a. Which of the two plans (stock acquisition or dividends) should the stockholders prefer? Why?

b. If you, the corporate president, held stock options, which of the two plans would you prefer? Why?