Question 17.2: Barston Mining has $100,000 in excess cash. Barston is consi...
Barston Mining has $100,000 in excess cash. Barston is considering investing the cash in one-year Treasury bills paying 2% interest, and then using the cash to pay a dividend next year. Alternatively, the firm can pay a dividend immediately and shareholders can invest the cash on their own. In a perfect capital market, which option would shareholders prefer?
Plan
We need to compare what shareholders would receive from an immediate dividend ($100,000) to the present value of what they would receive in one year if Barston invested the cash.
Execute
If Barston retains the cash, at the end of one year the company would be able to pay a dividend of 100,000 × (1.02) = $102,000. Note that this payoff is the same as if shareholders had invested the $100,000 in Treasury bills themselves. In other words, the present value of this future dividend is exactly 102,000 ÷ (1.02) = $100,000, which is the same as the $100,000 shareholders would receive from an immediate dividend. Thus, shareholders are indifferent about whether the firm pays the dividend immediately or retains the cash.
Evaluate
Because Barston is not doing anything that the investors could not have done on their own, it does not create any value by retaining the cash and investing it for the shareholders versus simply paying it to them immediately. As we showed with Genron in Example 17.1, if Barston retains the cash, but investors prefer to have the income today, they could sell $100,000 worth of shares.