PROBLEM 3: (6 points: 2 points for each part)

An all-equity company has the following year-end market value balance sheet:

Excess cash	$400,000		Debt	$0
Other assets	$3,600,000		Equity	$4,000,000 (80,000 shares at $50 per share)
Total	$4,000,000		Total	$4,000,000

The firm is considering the following alternative uses of excess cash:

Alternative 1: Pay out cash dividends.

Alternative 2: Repurchase its own stock.

Suppose you own 100 shares of the firm's common stock, and the company chooses Alternative 2 to repurchase its own stock:

1. Show with calculations that in absence of personal taxes and transaction costs, your wealth will be the same before and after the repurchase.

1. What will you do to create "home-made dividend" for yourself because the company did not pay out dividends under Alternative 1?

1. Suppose you had purchased the shares you own at $25 per share. Also suppose that the dividends are taxed at 30% and the capital gains are taxed at half the regular income tax rate of 40%. Suppose you create the home-made dividend in part b. How much difference will there be in the tax you will pay, compared to the tax you would have paid if the company had chosen Alternative 1?