Consider a firm F that generates a single cash-flow in one year which depends on the state of the economy:

-Boom (probability 1/2) 5m -Recession (probability 1/2) 1m

-F has 2,000 bonds outstanding with face value $1,000 and a 6% coupon, one year matu- rity.

-There are no taxes, and the risk free rate is 3%

-F has 1m cash at the beginning of year 1.

-F's cost of debt is 4% regardless of the payout policy they choose.

F can distribute at the beginning of year 1 either 70% of its cash or 30% of its cash. The cash retained by the firm is invested at the risk free rate.

Stockholders invest the dividend they receive at the beginning of year 1 at the risk free rate as well.

Question: 

Suppose that the market value of the bonds are 2m regardless of the payout policy chosen. The required return on the firm's assets is 10%, and the required return on equity if the firm had zero cash is 12%. Which of the two payout policies will the firm's shareholders optimally undertake and why?

Answer rating: 100% (QA)

To determine the optimal payout policy for F we need to calculate the total value of the firm under each policy and compare them Under the first polic... View the full answer