Case 4 (25 points)

1. Consider the following two statements: Dividend policy is irrelevant, and Stock price is the present value of expected future dividends. They sound contradictory. The current price of the shares of Charles River Mining Corporation is $50. Next years earnings and dividends per share are $4 and $2, respectively. Investors expect perpetual growth at 8% per year. The expected rate of return demanded by investors is r 12%. We can use the perpetual-growth model to calculate stock price Po= DIV/r-g = 2/.12-0.08 = 50 Suppose that Charles River Mining announces that it will switch to a 100% payout policy, issuing shares as necessary to finance growth. Use the perpetual growth model to show that the current stock price is unchanged.

2. If a company pays a dividend, the investor is liable for tax on the total value of the dividend (in the US). If instead, the company distributes the cash by stock repurchase, the investor is liable for tax only on any capital gains rather than on the entire amount (this situation is in the US other countries have different dividend tax policies). Therefore, even if the tax rates on dividend income and capital gains are the same, stock repurchase is always preferable to a dividend payment. Explain with a simple example why this is not the case. (Ignore the fact that capital gains may be postponed).