Clovix Corporation has $43 million in cash, 11 million shares outstanding, and a current share price of $25. Clovix is deciding whether to use the $43 million to pay an immediate special dividend of $3.91 per share, or to retain and invest it at the risk-free rate of 10% and use the $4.30 million in interest earned to increase its regular annual dividend of $0.39 per share. Assume perfect capital markets.
a. Suppose Clovix pays the special dividend. How can a shareholder who would prefer an increase in the regular dividend create it on her own?
b. Suppose Clovix increases its regular dividend. How can a shareholder who would prefer the special dividend create it on her own?
The Correct Answer and Explanation is :
Solution:
a. If Clovix pays the special dividend, how can a shareholder create an increase in the regular dividend?
If Clovix pays the $3.91 special dividend, shareholders receive cash immediately, reducing the company’s retained earnings by $43 million. A shareholder who prefers an increase in the regular dividend can reinvest the special dividend into additional shares of Clovix stock. Assuming perfect capital markets, the share price will drop by the amount of the special dividend ($3.91), reducing it from $25 to $21.09. The shareholder can use the cash from the special dividend to buy more shares at this lower price.
For example:
- A shareholder owning 1 share receives $3.91 as a special dividend.
- At the new share price of $21.09, the shareholder can purchase approximately ( \frac{3.91}{21.09} = 0.185 ) additional shares.
- By holding more shares, the shareholder will effectively increase the total dividends they receive over time, mirroring an increase in regular dividends.
b. If Clovix increases its regular dividend, how can a shareholder create the special dividend?
If Clovix retains the $43 million and increases the regular annual dividend from $0.39 to $0.78 (using the $4.30 million in interest), a shareholder who prefers the special dividend can create it by selling some of their shares.
For example:
- A shareholder owns 1 share worth $25.
- To create a $3.91 special dividend, the shareholder can sell ( \frac{3.91}{25} = 0.1564 ) of their shares.
- After selling, the shareholder still owns ( 1 – 0.1564 = 0.8436 ) shares.
- Future dividends will reflect the reduced number of shares but will be compensated by the immediate cash received.
Explanation:
These approaches leverage the principle of “homemade dividends” in perfect capital markets. In such markets:
- Shareholders can freely trade stocks with no transaction costs or taxes.
- Stock prices adjust to reflect corporate actions like dividends or retained earnings.
Thus, shareholders can adjust their cash flow preferences by buying or selling shares to either “smooth” future income or realize immediate cash.