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An all-equity company has the following market value balance sheet at the end of the year:
The firm is considering the following alternative uses of excess cash:
Alternative 1: pay out dividends.
Alternative 2: repurchase its own stock.
Suppose you own 600 shares of the firm's common stock:
a. Suppose the company chooses Alternative 2 to repurchase its own stock. What will you do to create "home-made dividend" for yourself because the company did not pay out dividends under Alternative 1?
b. Suppose you had purchased the shares you own at $10 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 a, how much difference will there be in the tax you will pay because the company chose Alternative 2, compared to the tax you would have paid if the company had chosen Alternative 1.
c. How many shares will you sell to have the after-tax cash amount equal to the after-tax cash amount you would have if the company were to pay out dividend under Alternative 1?
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