Corporate finance 2, total 10 easy questions. Chapter 18-20

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Effect of Cash Retention and Dividend Announcement

Harris Corporation has $250 million in cash, and 100 million shares outstanding. Suppose the corporate tax rate is 35%, and investors pay no taxes on dividends, capital gains, or interest income. Investors had expected Harris to pay out the $250 million through a share repurchase using permanent debt. Suppose instead that Harris announces it will permanently retain the cash, and use the interest on the cash to pay a regular dividend. If there are no other benefits of retaining the cash, how will Harris’ stock price change upon this announcement?

Instructions

Solution

The announcement that Harris Corporation will retain the cash and use the interest on the cash to pay a regular dividend could have an impact on the stock price. Let’s analyze the situation step by step:

Initially, investors expected Harris Corporation to use the $250 million cash to repurchase shares using permanent debt. This would effectively reduce the number of shares outstanding, which often leads to an increase in earnings per share (EPS) due to the same amount of earnings being distributed among a smaller number of shares. A higher EPS could potentially lead to a higher stock price, as investors often value companies based on their earnings potential.(Effect of Cash Retention and Dividend Announcement)

However, in the new scenario, Harris decides to retain the cash and use the interest earned on it to pay a regular dividend. This means that the company is not using the cash to reduce the number of shares outstanding, which could result in a lower EPS compared to the scenario where shares were repurchased.

Given that there are no other benefits mentioned for retaining the cash, investors might view this decision as less favorable than the share repurchase plan. Here are a few factors to consider:(Effect of Cash Retention and Dividend Announcement)

1. Dividend Yield: The regular dividend payments from the interest on the cash might provide some return to investors, but if the yield (dividend amount divided by stock price) is not competitive compared to other investment opportunities, it might not be seen as attractive.
2. Earnings Per Share (EPS): With the number of shares outstanding remaining the same, the EPS might not experience the same boost as it would have with a share repurchase. This could potentially impact how investors value the company’s stock.
3. Perceived Value: Share repurchases often signal that a company believes its stock is undervalued, which can positively influence investor sentiment. The decision to retain cash instead might be interpreted as lacking confidence in the company’s growth prospects.(Effect of Cash Retention and Dividend Announcement)
4. Tax Considerations: The fact that investors pay no taxes on dividends, capital gains, or interest income works in favor of the dividend plan. However, the EPS-driven increase in stock price due to share repurchases could potentially outweigh the tax advantages in terms of its impact on stock price.(Effect of Cash Retention and Dividend Announcement)

Considering these factors, it’s possible that the stock price might experience a negative reaction to the announcement of retaining cash for dividend payments compared to the original expectation of a share repurchase. However, the exact magnitude of the price change would depend on various market dynamics, investor sentiment, and broader economic conditions.(Effect of Cash Retention and Dividend Announcement)

Reference

https://www.ncbi.nlm.nih.gov/