18

Chapter 18 (ST-1) component manufacturing corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock outstanding. When CMCs founders, who was also its research director and most successful inventor, retired unexpectky to the south pacific in late 2004, cmc was left suddenly and permenantly with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to repace the founders contribution to the firm. Previously, CMC found it necessary to plow back most of its earning to finance growth, which averaged 12 percent per year. Future growth at a 5% rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects with at least the 14 % rate of return required by CMCs stockholders (rs=14%) would amount to only $800,000 for 2005 in comparison to a projected $ 2,000,000 of net income. If the existing 20% divided payout were continued, retained earnings would be $1,6 million in 2005, but, as noted, investments that yield the 14 % cost of capital would amount to only $800,000. The one encouraging thing is that the high earnings from existing assets are expected to continue, and net income of $2 million is still expected for 2005. given the dramatically changed circumstances, CMCs management is reviewing the firms dividend policy. a. assuming that the acceptable 2005 investment projects would be financed entirely by earnings retained during the year, calculate DPS in 2005, assuming that CMC uses the residual distribution model and pays all distributions in the form of dividends. b. What payout ratio does your answer to part a imply for 2005? c. If a 60% payout ratio is maintained for the foresseable future, what is your estimate of the present market price of the common stock? How does this compare with the market proce that should have prevailed under the assumption existing just before the news about the founders retirement? If the two values of Po are different, comment on why. Solution (ST-1) a. projected net income less projected capital investment available residual shares outstanding DPS= $1,200,000/200,000 shares = $6 = D1

$2,000,000 800,000 $1,200,000 200,000

b. EBS=$2,000,000/200,000 shares = $10. Payout ratio = DPS/EPS = $6/$10 = 60% c. currently, Po= D1/(rs-g) = $6/(0.14-0.05) = $6/0.09 = $66.67 under the former circumstances, D1 would be based on a 20% payout on $10 EPS, or $2. with rs= 14% and g= 12%, we solve foe Po : Po = D1/(rs-g) = $2/(0.14-0.12) = $2/0.02 = $100 Although CMC has suffered a severe setback, its existing assets will continue to provide a good income stream. More of these earnings should now be passed on to the shareholders, as the slowed internal growth has reduced the need for funds. However, the net result is a 33% decrease in the value of the shares. (18-1) axel telecommunications has a target capital structure that consists of 70 % dept and 30% equity. The company anticipates that its capital budget for the upcoming year will be $3,000,000. if Axel reports net income of $2,000,000 and it follows a residual distribution model with all distributions as dividends, what will be its dividend payout ratio? 70% Debt; 30% Equity; Capital Budget = $3,000,000; NI = $2,000,000; PO = ? Equity retained = 0.3($3,000,000) = $900,000. NI -Additions Earnings Remaining

$2,000,000 900,000 $1,100,000

$1,100,000

Payout = $2,000,000 = 55%. (18-2) Gamma Medicals stock trades at $90 a share. The company is contemplating a 3-for-2 stock split. Assuming that the stock split will have no effect on the total market value of its equity, what will be the companys stock price following the stock split? P0 = $90; Split = 3 for 2; New P0 = ? P0 New =

$90 = $60. 3/ 2

(18-3) northern pacific heating and cooling Inc. has a 6 month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 40% with a $10 million investment in plant and machinery. The firm wants to maintain a 40% dept-to-total-assets ratio in its capital structure, it also wants to maintain its past dividend policy of distributing 45% of last year net income. In 2004, net income was $5 million. How much external equity must northern pacific seek at the beginning of 2005 to expand capacity as desired?

Retained earnings = Net income (1 - Payout ratio) = $5,000,000(0.55) = $2,750,000. External equity needed: Total equity required = (New investment)(1 - Debt ratio) = $10,000,000(0.60) = $6,000,000. New external equity needed = $6,000,000 - $2,750,000 = $3,250,000. (18-4) Petersen company has a capital budget of $1.2 million. The company wants to maintain a target capital structure which is 60% dept and 40% equity the company forecasts that its net income this year will be $600,000. if the company follows a residual distribution model and pays all distributions as dividends, what will be its payout ratio? The company requires 0.40($1,200,000) = $480,000 of equity financing. If the company follows a residual dividend policy it will retain $480,000 for its capital budget and pay out the $120,000 “residual” to its shareholders as a dividend. The payout ratio would therefore be $120,000/$600,000 = 0.20 = 20%. (18-5) the wei corporation expects next year net income to be $15 million. The firm's debt ratio is currently 40%. Wei has $12 million of profitable investment opportunities, and it wishes to maintain its existing debt ratio. According to the residual distribution model (assuming all payments are in the form of dividends), how large should weis dividend payout ratio be next year? Equity financing = $12,000,000(0.60) = $7,200,000. Dividends = Net income - Equity financing = $15,000,000 - $7,200,000 = $7,800,000. Dividend payout ratio = Dividends/Net income = $7,800,000/$15,000,000 = 52%. (18-6) after a 5-for-1 stock split, the Strasburg company paid a dividend of $0.75 per new share, which represent a 9% increase over last years pre-split dividend . What was last year dividend per share? 18-6 DPS after split = $0.75. Equivalent pre-split dividend = $0.75(5) = $3.75. New equivalent dividend = Last year’s dividend(1.09) $3.75 = Last year’s dividend(1.09) Last year’s dividend = $3.75/1.09 = $3.44. (18-7) the Welch company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented below: Project H (high risk) Project M (medium risk)

cost of capital = 16%; IRR=20% cost of capital = 12%; IRR=10%

Project L (low risk)

cost of capital = 8%; IRR=9%

Note that the projects cost of capital varies because the projects have different levels of risks. The company's optimal capital structure calls for 50% debt and 50% common equity. Welch expects to have net income of $7,287,500. If Welch bases its dividends on the residual model (all distribution are in the form of dividends), what will its payout ratio be? 18-7 Capital budget should be $10 million. We know that 50% of the $10 million should be equity. Therefore, the company should pay dividends of: Dividends Payout ratio

= Net income - needed equity = $7,287,500 - $5,000,000 = $2,287,500. = $2,287,500/$7,287,500 = 0.3139 = 31.39%.