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ABC Corp. has 2 million shares outstanding and no debt. Each year, it generates (on average) a $9.6m cash flow which it pays as a regular dividend. ABC's cost of capital is 12% which, since it has no debt, is also its expected return on equity. ABC's CEO plans to borrow 58m and use the proceeds immediately to pay shareholders an exceptional dividend. This level of debt would be risk-free, i.e. the firm would be certain not to default on its obligation to pay it. The risk-free interest rate is 5%. Answer the following assuming the transaction (borrowing + dividend) has already occurred and that financial markets are "perfect".
a. What is ABC's new stock price? Compare it to the initial stock price. Explain.
b. Are ABC's shareholders happy about the CEO's change in policy?
c. What is ABC's annual interest expense? Assuming ABC maintains its policy of paying all cash flows as dividend, what is the new average regular annual dividend per share?
d. What is ABC's new expected return on equity? Compare it to the initial 12%. Explain.
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