Reference no: EM133050731

Question - Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected to grow by 5 percent a year in perpetuity. However, the company has heard that the value of a share depends on the flow of dividends, and therefore it announces that next year's dividend will be increased to $2 million and that the extra cash will be raised immediately afterward by an issue of shares. After that, the total amount paid out each year will be as previously forecasted, that is, $1.05 million in year 2 and increasing by 5 percent in each subsequent year.

Assume that new shares are issued in year 1 at $10 a share. Show who gains and who loses. Is dividend policy still irrelevant? Why or why not?