Chapter 18

(ST-1) component manufacturing corporation (CMC) has an all-common-equity

capital structure. It has 200000 shares of !2 par "alue common stoc# outstan$ing.
%hen CMCs foun$ers &ho &as also its research $irector an$ most successful
in"entor retire$ une'pect#y to the south pacific in late 200( cmc &as left su$$enly
an$ permenantly &ith materially lo&er gro&th e'pectations an$ relati"ely fe&
attracti"e ne& in"estment opportunities. )nfortunately there &as no &ay to repace
the foun$ers contri*ution to the firm. +re"iously CMC foun$ it necessary to plo&
*ac# most of its earning to finance gro&th &hich a"erage$ 12 percent per year.
,uture gro&th at a -. rate is consi$ere$ realistic *ut that le"el &oul$ call for an
increase in the $i"i$en$ payout. ,urther it no& appears that ne& in"estment pro/ects
&ith at least the 1( . rate of return require$ *y CMCs stoc#hol$ers (r
s
01(.) &oul$
amount to only !100000 for 200- in comparison to a pro/ecte$ ! 2000000 of net
income. If the e'isting 20. $i"i$e$ payout &ere continue$ retaine$ earnings &oul$
*e !12 million in 200- *ut as note$ in"estments that yiel$ the 1( . cost of capital
&oul$ amount to only !100000.
The one encouraging thing is that the high earnings from e'isting assets are e'pecte$
to continue an$ net income of !2 million is still e'pecte$ for 200-. gi"en the
$ramatically change$ circumstances CMCs management is re"ie&ing the firms
$i"i$en$ policy.
a. assuming that the accepta*le 200- in"estment pro/ects &oul$ *e finance$
entirely *y earnings retaine$ $uring the year calculate 3+S in 200- assuming
that CMC uses the resi$ual $istri*ution mo$el an$ pays all $istri*utions in the
form of $i"i$en$s.
*. %hat payout ratio $oes your ans&er to part a imply for 200-4
c. If a 20. payout ratio is maintaine$ for the foressea*le future &hat is your
estimate of the present mar#et price of the common stoc#4 5o& $oes this
compare &ith the mar#et proce that shoul$ ha"e pre"aile$ un$er the
assumption e'isting /ust *efore the ne&s a*out the foun$ers retirement4 If the
t&o "alues of +
o
are $ifferent comment on &hy.
Solution
(ST-1)
a. pro/ecte$ net income !2000000
less pro/ecte$ capital in"estment 100000
a"aila*le resi$ual !1200000
shares outstan$ing 200000
3+S0 !12000006200000 shares 0 !2 0 3
1
*. 78S0!20000006200000 shares 0 !10.
+ayout ratio 0 3+S67+S 0 !26!10 0 20.
c. currently +
o
0 3
1
6(r
s
-g) 0 !26(0.1(-0.0-) 0 !260.09 0 !22.2:
un$er the former circumstances 3
1
&oul$ *e *ase$ on a 20. payout on !10 7+S or
!2. &ith r
s
0 1(. an$ g0 12. &e sol"e foe +
o
;
+
o 0
3
1
6(r
s
-g) 0 !26(0.1(-0.12) 0 !260.02 0 !100
<lthough CMC has suffere$ a se"ere set*ac# its e'isting assets &ill continue to
pro"i$e a goo$ income stream. More of these earnings shoul$ no& *e passe$ on to the
sharehol$ers as the slo&e$ internal gro&th has re$uce$ the nee$ for fun$s. 5o&e"er
the net result is a ==. $ecrease in the "alue of the shares.
(11-1) a'el telecommunications has a target capital structure that consists of :0 .
$ept an$ =0. equity. The company anticipates that its capital *u$get for the
upcoming year &ill *e !=000000. if <'el reports net income of !2000000 an$ it
follo&s a resi$ual $istri*ution mo$el &ith all $istri*utions as $i"i$en$s &hat &ill *e
its $i"i$en$ payout ratio4
:0. 3e*t> =0. 7quity> Capital 8u$get 0 !=000000> ?I 0 !2000000>
+@ 0 4
7quity retaine$ 0 0.=(!=000000) 0 !900000.
?I !2000000
-<$$itions 900000
7arnings Aemaining !1100000
+ayout 0
000 000 2 !
000 100 1 !
0 --..
(11-2) Bamma Me$icals stoc# tra$es at !90 a share. The company is contemplating a
=-for-2 stoc# split. <ssuming that the stoc# split &ill ha"e no effect on the total
mar#et "alue of its equity &hat &ill *e the companys stoc# price follo&ing the stoc#
split4
+
0
0 !90> Split 0 = for 2> ?e& +
0
0 4
+
0 ?e&
0
2 6 =
90 !
0 !20.
(11-=) northern pacific heating an$ cooling Inc. has a 2 month *ac#log of or$ers for
its patente$ solar heating system. To meet this $eman$ management plans to e'pan$
pro$uction capacity *y (0. &ith a !10 million in"estment in plant an$ machinery.
The firm &ants to maintain a (0. $ept-to-total-assets ratio in its capital structure it
also &ants to maintain its past $i"i$en$ policy of $istri*uting (-. of last year net
income. In 200( net income &as !- million. 5o& much e'ternal equity must northern
pacific see# at the *eginning of 200- to e'pan$ capacity as $esire$4
Aetaine$ earnings 0 ?et income (1 - +ayout ratio)
0 !-000000(0.--) 0 !2:-0000.
7'ternal equity nee$e$;
Total equity require$ 0 (?e& in"estment)(1 - 3e*t ratio)
0 !10000000(0.20) 0 !2000000.
?e& e'ternal equity nee$e$ 0 !2000000 - !2:-0000 0 !=2-0000.
(11-() +etersen company has a capital *u$get of !1.2 million. The company &ants to
maintain a target capital structure &hich is 20. $ept an$ (0. equity the company
forecasts that its net income this year &ill *e !200000. if the company follo&s a
resi$ual $istri*ution mo$el an$ pays all $istri*utions as $i"i$en$s &hat &ill *e its
payout ratio4
The company requires 0.(0(!1200000) 0 !(10000 of equity financing. If
the company follo&s a resi$ual $i"i$en$ policy it &ill retain !(10000
for its capital *u$get an$ pay out the !120000 Cresi$ualD to its
sharehol$ers as a $i"i$en$. The payout ratio &oul$ therefore *e
!1200006!200000 0 0.20 0 20..
(18-5) the wei corporation expects next year net income to be $15 million. The
firm's debt ratio is crrently !"#. $ei has $1% million of profitable in&estment
opportnities' and it wishes to maintain its existin( debt ratio. )ccordin( to the
residal distribtion model (assmin( all payments are in the form of di&idends)'
how lar(e shold weis di&idend payot ratio be next year*
7quity financing 0 !12000000(0.20) 0 !:200000.
3i"i$en$s 0 ?et income - 7quity financing
0 !1-000000 - !:200000 0 !:100000.
3i"i$en$ payout ratio 0 3i"i$en$s6?et income
0 !:1000006!1-000000 0 -2..
(18-+) after a 5-for-1 stoc, split' the -trasbr( company paid a di&idend of $"..5
per new share' which represent a /# increase o&er last years pre-split di&idend .
$hat was last year di&idend per share*
11-2 3+S after split 0 !0.:-.
7qui"alent pre-split $i"i$en$ 0 !0.:-(-) 0 !=.:-.
?e& equi"alent $i"i$en$ 0 East yearFs $i"i$en$(1.09)
!=.:- 0 East yearFs $i"i$en$(1.09)
East yearFs $i"i$en$ 0 !=.:-61.09 0 !=.((.
(18-.) the $elch company is considerin( three independent pro0ects' each of
which re1ires a $5 million in&estment. The estimated internal rate of retrn
(233) and cost of capital for these pro0ects are presented below4
5ro0ect 6 (hi(h ris,) cost of capital 7 1+#8 2337%"#
5ro0ect 9 (medim ris,) cost of capital 7 1%#8 23371"#
5ro0ect : (low ris,) cost of capital 7 8#8 2337/#
;ote that the pro0ects cost of capital &aries becase the pro0ects ha&e different
le&els of ris,s. The company's optimal capital strctre calls for 5"# debt and
5"# common e1ity. $elch expects to ha&e net income of $.'%8.'5"". 2f $elch
bases its di&idends on the residal model (all distribtion are in the form of
di&idends)' what will its payot ratio be*
11-: Capital *u$get shoul$ *e !10 million. %e #no& that -0. of the !10 million
shoul$ *e equity. Therefore the company shoul$ pay $i"i$en$s of;
3i"i$en$s 0 ?et income - nee$e$ equity
0 !:21:-00 - !-000000 0 !221:-00.
+ayout ratio 0 !221:-006!:21:-00 0 0.=1=9 0 =1.=9..