Reading: Adjusting the Capital Structure

The first alternative is that the firm borrows 2'500 and pays it out as a dividend. Because the additional debt of 2'500 is directly paid out to shareholders, the left side of the balance sheet at market values does not change from the time of the announcement (\(V_L'\)) to the time after the transaction (\(V_L^*\)):

However, since there is now a debt claim of 2'500 (D*) against firm value, the market value of equity (\(E_L^*\)) drops to 1'625 after the recapitalization:

\( E_L^* = V_L* - \text{D*} = 4'125 - 2'500 = 1'625 \).

Put differently, after the recapitalization, shareholders hold 2'500 in cash from the dividend plus the firm's equity with a total value of 1'625. Therefore, shareholder value is NOT affected by the dividend payment—it remains at the post-announcement level of 4'125. 

Finally, the stock price drops from 8.25 after the announcement (P') to 3.25 after the dividend payment (P*):

\(P^* = \frac{E_L^*}{N*}=\frac{1'625}{500}=3.25\).

This price drop by 5 is not surprising. With 500 shares outstanding, a total payout of 2'500 translates into a dividend per share of 5:

 P* = P' - Dividend = 8.25 - 5.00 = 3.25.

  
After the transaction, each shareholder will therefore own a share with a value of 3.25 (P*) plus a cash dividend of 5. The total value per share is therefore 8.25, which is the same as right after the announcement. As already stated above, the decision to pay a dividend does therefore not affect total shareholder wealth.