Question

Hong Kong has an unusual tax system. Dividends and capital gains are not taxable. The Peng Corporation currently pays a quarterly dividend of HK$5 per share. It has 5 m shares outstanding at a price of HK$267 a. What will happen to the share price on the first day when registered owners are no longer eligible to receive the quarterly dividend? b. What will happen to the share price if Peng announces that in the future it will cut quarterly dividends by HK$2 per share and use the cash to repurchase shares instead? c. What if Peng keeps the dividend at HK$5 but uses excess cash to repurchase shares in the open market at the current market price of HK$267?

Answer 1

a) If Peng stops paying the $ 5 dividend, on the first day the share price is likely to fall on account of re-rating of the stock as the return on equity for investors would have reduced by $5 & hence the valuation of the company is likely to reduce. Hence technically the re-rating should happen along the following dimensions:

1) you could expect the share price to fall by the an amount equivalent to the NPV of the loss of $5 when calculated in perpetuity.

2) You could expect the share price to readjust to to $262 which is a flat $5 drop in the share price

b) Here the company has done 1 positive action and one negative action that affect the short term share price of the share

1) Reducing the dividend from $5 to $2 is definately expected to hit the return on equity for share holders & hence unilaterally would have led to a $3 discount in the share price

2) Buying back shares from the $3 not paid out as dividend will lead to a proportionate reduction in the number of stocks in circulation thereby increasing the value of the company (if done unilaterally) as there are now lesser stocks in question for the same return.

However when we look at both these changes together, the stock is unlikely to change its price as both the earnings per share & the number of shares are going to reduce proportionately and hence the return on equity will not change. Also as both capital gains & dividend gains are non taxable there will be no change. Had one of them been taxable then the stock would have re-rated accordingly.

c) In this case the share price is definately going to rise. Reason for this has already been given in the previous answer but I still reiterate. As the earnings per share are not changing however the number of shares in circulation are going to reduce, the value of each share will rise. Hence the share price is likely to increase as a consequence of this.