Assigned Problems Module 3 Valuation and Concept Methods PDF

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Cordero, Agustina Donato, Dianne Ibanez, Jade Myrrh Liz Sansaet, Rizalyn BSA 2A FINMARProblem 16-After a 5-for-1 stock split, Iskandar Company paid a dividend of $0 per new share representing a 9% increase over last year’s pre-split dividend. What was last year’s dividend per share?Answer: = $0 / (1...

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Cordero, Agustina Donato, Dianne Ibanez, Jade Myrrh Liz Sansaet, Rizalyn BSA 2A

FINMAR

Problem 16-4 After a 5-for-1 stock split, Iskandar Company paid a dividend of $0.90 per new share representing a 9% increase over last year’s pre-split dividend. What was last year’s dividend per share?

Answer: = $0.90 / (1+9%) Pre-split dividend = $0.8257 = $0.8257 x 5 = $ 4.13

Problem 16-5 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% debt-to-total-assets ratio in its capital structure. It also wants to maintain its past dividend policy of distributing 45% of last year’s net income. In 2008, net income was $5 million. How much external equity must Northern Pacific seek at the beginning of 2009 to expand capacity as desired? Assume that the firm uses only debt and common equity in its capital structure.

Answer: -

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

PROBLEM 16-6 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 here:

Project H (high risk):

Cost of capital = 16%

IRR = 20%

Project M (medium risk):

Cost of capital = 12%

IRR = 10%

Project L (low risk):

Cost of capital = 8%

IRR = 9%

Solution: Project H and Project L would be undertaken because their IRRs are more than the cost of capital. Project M would not be accepted as its IRR is lower than the cost of capital. Total investment = $5 million x 2 projects = $10 million.

Dividends = Net income – (Target equity ratio x Total capital budget) $7,287,500 – (50% x $10 million) $6,787,500

Dividend pay-out ratio = Dividends/net income x 100 =$2,287,500/$7,287,500 x 100 =31.39%

Problem 16-7 Bowles Sporting Company is prepared to report the following 2012 income statement (shown in thousands of dollars).

Sales

$15,200

Operating costs including depreciation

$11,900

EBIT

$ 3,300

Interest

$ 300

EBT

$3,000

Taxes (40%)

$ 1,200

Net Income

$ 1,800

Prior to reporting this income statement, the company wants to determine its annual dividend. The company has 500,000 shares of stock outstanding, and its stock trades at $48 per share. a. The company had a 40% dividend payout ratio in 2014. If Bowles wants to maintain this payout ratio in 2015, what will be its per-share dividend in 2015?

Dividend payout ratio = Dividend/ Net Income Dividend payout ratio = 40%

Net income = $1,800,000 Number of shares = 500,000 Dividend (2012) = 40% x Net Income (2012) = 40% ($1,800,000) = $720,000 Per-share dividend = Dividends / No. Of Shares Outstanding = 720,000/500 = $1.44

b. If the company maintains this 40% payout ratio, what will be the current dividend yield on the company’s stock?

Dividend Yield = (Dividend per share x common stock) x 100% = ($1.44 x $48) x 100% = 3% c. The company reported net income of $1.5 million in 2014. Assume that the number of shares outstanding has remained constant. What was the company’s per-share dividend in 2014?

Dividend payout ratio = Dividend/ Net Income Dividend payout ratio = 40% Net income = $1,500,000 Dividend = $60,000 Number of shares = 500,000

Dividend (2011) = 40% x Net Income (2011) = 40% ($1,500,000) = $600,000

Per-share dividend = Dividends / No. Of Shares Outstanding = 600,000/ 500,000 = $1.20

d. As an alternative to maintaining the same dividend payout ratio, Bowles is considering maintaining the same per share dividend in 2015 that it paid in 2014. If it chooses this policy, what will be the company’s dividend payout ratio in 2015?

Per-share dividend (2014) = $1.20 Maintaining the same per-share dividend in 2015, Dividends

= Per-share dividend x No. of shares outstanding = $1.20 x 500,000 = $600,000

Dividend payout ratio = Dividend / Net Income = $600,000/ 1,800,000 = 33.33% Therefore, maintaining the same per-share dividend does not maintain the same dividend payout ratio.

e. Assume that the company is interested in dramatically expanding its operations and that this expansion will require significant amounts of capital. The company would like to avoid transactions costs involved in issuing new equity. Given this scenario, would it make more sense for the company to maintain a constant dividend payout ratio or to maintain the same per-share dividend? Explain. Since the company would like to avoid transaction costs involved in issuing new equity, it would be best for the firm to maintain the same pre-share dividend. This will provide a stable dividend to investors, yet allow the firm to expand operations without significantly affecting the dividend. A constant dividend payout ratio would cause serious fluctuations to dividends depending on the level of earnings. If earnings are high, then dividends would be high. However, if earnings are low, then dividends would be low. This would

cause great uncertainty for investors regarding dividends and would cause the firm’s stocks to decline because investors prefer a more stable dividend policy.

Problem 16-8 Rubenstein Bros. Clothing is expecting to pay an annual dividend per share of $0.75 out of annual earnings per share of $2.25. Currently, Rubenstein Bros.’ stock is selling for $12.50 per share. Adhering to the company’s target capital structure, the firm has $10million in assets, of which 40% is funded by debt. Assume that the firm’s book value of equity equals its market value. In past years, the firm has earned a return on equity (ROE) of 18%, which is expected to continue this year and into the foreseeable future.

Information Extracted DPS = $0.75 EPS = $2.25 Stock Price = $12.50 Total assets = $10million Debt / Asset = 40% ROE = 18% Book Value of Equity = Market Value

a) Based on that information, what long-run growth rate can the firm be expected to maintain? (Hint: g = Retention rate x ROE)

Payout ratio dividend = Dividend per share/Earnings per share = 0.75/2.25 = 0.3333 Retention rate = 1 – Dividend payout ratio = 1 – 0.3333 = 0.67

g = Retention rate x ROE = 0.67 x 0.18 = 0.1206 or 12.06%

b)

What is the stock’s required return?

Market price of the rate = Dividend (1 + growth)/Required of return – growth 12.50

= 0.75 (1 + 0.1206)/Required rate of return – 0.1206

12.50

= 0.75 (1.1206)/Required rate of return – 0.1206

Required rate of return – 0.1206 = 0.84045/12.50 Required rate of return = 0.06724 + 0.1206 Required rate of return = 0.18784 or 18.80%

c) If the firm increased their annual dividend to $1.50 per share, analysts predict there will no change in the firm’s stock price or ROE. Find the firm’s new expected long-run growth rate and required return.

Payout ratio = Dividend per share/Earnings per share = 1.50/2.25 = 0.67 Retention rate = 1 – Dividend payout ratio = 1 – 0.67 = 0.33

g = Retention rate x ROE = 0.33 x 0.18 = 0.0594 or 5.94%

Market price of the rate = Dividend (1 + growth)/Required of return – growth 12.50

= 1.50 (1.0594)/ Required of return – 0.0594

12.50

= 1.5891/ Required of return – 0.0594

Required of return – 0.0594 = 1.5891/12.50 Required of return = 0.12713 + 0.0594 Required of return = 0.1865 or 18.65%

d) Suppose instead that the firm has decided to proceed with its original plan of disbursing $0.75 per share to shareholders, but the firm intends to do so in the form of a stock dividend rather than a cash dividend. The firm will allot new shares based on the current stock price of $12.50. In other words, for every $12.50 in dividends due to shareholders, a share of stock will be issued. How large will the stock dividend be relative to the firm's current market capitalization? (Hint: Remember that market capitalization = P x number of shares outstanding.) Equity ratio = 100% - 40% = 60%

Equity capital = Total invested capital x Equity ratio = $10,000,000 x 60%

= $6,000,000

Net Income = Equity capital x Return on equity = $6,000,000 x 18% = $1,080,000

Earnings per share = Net Income/No. of shares 2.25

= $1,080,000/ No. of shares

No. of shares

= $1,080,000/$2.25

No. of shares

= 480,000 shares

Total dividend = No. of shares x Dividends per share = 480,000 shares x $0.75 = $360,000

Market capitalization = Po x No. of shares = $12.50 x 480,000 = $6,000,000

Rate of dividend to market Capitalization rate = Total Dividend/Market Capitalization = $360,000/$6,000,000 = 0.06 or 6%

e. If the plan in part d is implemented, how many new shares of stock will be issued, and by how much will the company's earnings per share be diluted? Thus, if the plan in part d is implemented, the firm’s earning per share be diluted at the capitalization rate of 6% with 480,000 number of shares. Earnings per share = Net Income/No. of shares 2.25

= $1,080,000/ No. of shares

No. of shares

= $1,080,000/$2.25

No. of shares

= 480,000 shares

Rate of dividend to market Capitalization rate = Total Dividend/Market Capitalization = $360,000/$6,000,000 = 0.06 or 6%

PROBLEM 16-9 In 2014, Keenan Company paid dividends totaling 3,600,000 on net income of $10.8 million. Note that 2014 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2015, earnings are expected to jump to $14.4 million and the firm expects to have profitable investment opportunities of $8.4 million.It is predicted that Keenan will not be able to maintain the 2015 level of earnings growth because the high 2015 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2015, the company will return to its previous 10% growth rate. Keenan's target capital structure is 40% debt and 60% equity.

a. Calculate Keenan's total dividends for 2015 assuming that it follows each of the following policies:

1. Its 2015 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. Dividends 2014 = $3.6M Long Term Growth Rate = 10% Dividends 2015 = $3.6M x (1 + g) Dividends 2015 = $3.6M x (1 .1) Dividends 2015 = $3,960,000

2. It continues the 2014 dividend payout ratio. Dividend Payout Ratio 2014 = $3,600,000/10,800,000 =33.33% Dividend 2015 = $14.4M x 33.33% Dividends 2015 = $4,800,000

3. It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt and 60% with common equity) Dividend 2015 = Net Income – [(Target Equity Ratio)(Total Capital Budget)] Dividend 2015 = $14.4M – [(60%)($8.4M)] Dividend 2015 = $9.36M

4. It employs a regular-dividend-plus-extras policy, with the regular. dividend being based on the long-run growth rate and the extra dividend being set according to the residual dividend policy. Regular dividend component= (1.10)($3,600,000) = $3,960,000 Extra Dividend = $9,360,000-$3,960,000 Extra Dividend = $5,400,000

b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer.

I'd go with the first option. The expected increase in net income for 2011 appears unusual, especially given that the passage states that the company will be unable to maintain earnings growth. If Keenan were a technology firm, the "new product line" introduced might not be stable enough, and I would opt for the most conservative distribution payment.

c. Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2015 and to have the dividend grow at 10% after 2015. The stock's total market value is $180 million. What is the company's cost of equity?

Cost of equity (rs) = D1/ P0+ g Cost of equity = $9,000,000/$180,000,000 + 0.10 Cost of equity = 0.15 or 15%

d. What is Keenan's long-run average return on equity? [Hint: 8= Retention rate x ROE = (1.0-Payout rate)(ROE).]

Growth (g) = Retention rate × ROE ROE = g / Retention rate ROE = 0.10 / [1 – ($3,600,000 / $10,800,000] ROE= 0.15 or 15%

e. Does a 2015 dividend of $9,000,000 seem reasonable in view of you answers to parts c and d? If not, should the dividend be higher a lower? Explain your answer.

A dividend of $9,000,000 in 2015 may seem a little low, given that the firm's cost of equity is 15% and it provides an average return on equity (ROE) of 15%. However, an average return on equity of 15% implies that there are assets or projects earning less

than this return and that the marginal return is less than 15%. This implies that the capital budget is too large, and that some funds are being invested in unprofitable assets, and that more dividends should be paid out instead. However, there is some uncertainty with this conclusion because it is possible that the firm is earning low returns (say, 10%) on existing assets and has extremely profitable opportunities in 2012 (say, 30%), resulting in an expected overall average ROE of 15%. Maximizing investment funding and paying a lower dividend would be justified in this case....