The Horner Pie Company
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Question 11a) The Horner Pie Company pays a quarterly dividend of $1.  Suppose that the stock price is expected to fall on the ex-dividend date by $.90.  Would you prefer to buy on the with-dividend date or the ex-dividend date if you were (i) a tax-free investor, (ii) an investor with a marginal tax rate of 40 percent on income and 16 percent on capital gains? Suppose the stock price is expected to fall by $0.90 with a dividend of $1, the investor should buy it on the with-dividend date because the dividend is still worth a dollar and the fall is only $0.90. The investor should buy this at the ex-dividend date because of the marginal tax rate. The marginal tax rate of 40% on a dividend of $1 is $0.60 which is less than the fall of $0.90. 1b) In a study of ex-dividend behavior, Elton and Gruber estimate that the stock price fell on average by 85 percent of the dividend.  If the tax rate on capital gains was 40 percent of the rate on income tax, what did Elton and Gruber’s result imply about investors’ marginal rate of income tax? The choice between with dividend or ex-dividend should not matter in this scenario. So, Return from buying with-dividend stocks = 0 = 0.4*t*0.85 + (1-t)– 0.85 = 0.23 or 23%. 1c)  Elton and Gruber also observed that the ex-dividend price fall was different for high-payout stocks and for low-payout stocks.  Which group would you expect to show the larger price fall as a proportion of the dividend? The high-payout stocks will show the larger price fall as a proportion of the dividend. This is because investors will be holding these shares in the very low tax brackets.
1d)  Would the fact that investors can trade stocks freely around the ex-dividend date alter your interpretation of Elton and Gruber’s study? No it will not alter our interpretation of the study because, investors can still have choice between dividends or stock gains.  Question 2ABC is all equity financed, has 1 million shares outstanding and a current stock price of $10. Although management believes the stock is valued, they came across some obscure research on share buybacks that shows that companies announcing repurchase tender offers see their stock prices increase significantly. If the company makes a fixed price tender offer at a premium (PREMIUM) above the market price for 20 % of the shares, the short-term percentage abnormal return to the non-tendering shareholders after the announcement of a tender offer can be estimated as                     % AR = 0.6 × PREMIUM + 0.25 × 0.2 = 0.6 × PREMIUM + 5 %The management is concerned about the stock price as Joe Raider is on the prowl and may make a hostile bid for the company during the next month. The management is particularly concerned as Joe wants to eliminate their perks ($2 million worth (in present value) of spending on corporate jets, plush offices, executive courses on the Bahamas).  Management owns 20 % of the shares and cannot participate in a tender offer. It is advised by Bill Slick who points out that the probability of a takeover bid is inversely related to the stock price. Specifically, the probability is equal to min(1, 3/p), where p is the stock price. Bill Slick also mentions that he expects Joe Raider to offer a 40% premium to the market price. If the company decides to make a buyback tender offer, the “market price” will be the post-expiration price. In other words, Joe Raider will only make his bid after the buyback tender offer is over.