14-2 Would each of the following increase, decrease, or have an indeterminant effect on a firm’s break-even point

(unit sales)?
1. The sales price increases with no change in unit costs.
2. An increase in fixed costs is accompanied by a decrease in variable costs.
3. A new firm decides to use MACRS depreciation for both book and tax purposes rather
than the straight-line depreciation method.
4. Variable labor costs decline; other things are held constant.
14-4 If Congress increased the personal tax rate on interest, dividends, and capital gains but simultaneously
reduced the rate on corporate income, what effect would this have on the average company’s capital structure?
An increase in the personal tax rate makes both stocks and bonds less attractive to investors because it raises the
tax paid on dividend and interest income. Changes in personal tax rates will have differing effects, depending on
what portion of an investment’s total return is expected in the form of interest or dividends versus capital gains.
For example, a high personal tax rate has a greater impact on bondholders because more of their return will be
taxed sooner at the new higher rate. An increase in the personal tax rate will cause some investors to shift from
bonds to stocks because of the attractiveness of capital gains tax deferrals. This raises the cost of debt relative to
equity. In addition, a lower corporate tax rate reduces the advantage of debt by reducing the benefit of a
corporation’s interest deduction that discourages the use of debt. Consequently, the net result would be for firms
to use more equity and less debt in their capital structures.
14-7 Why is EBIT generally considered independent of financial leverage? Why might EBIT actually be affected by
financial leverage at high debt levels?
Independent of financial leverage (debt) so no impact. BUT if theres a risk of bankruptcy it could impact them on
a day to day basis tho
14-8 Is the debt level that maximizes a firm’s expected EPS the same as the debt level that maxi- mizes its stock
price? Explain.
Stock price isn’t necessarily correlated to Earnings per share

14-10 When the Bell System was broken up, the old AT&T was split into a new AT&T and seven regional telephone
companies. The specific reason for forcing the breakup was to increase the degree of competition in the telephone
industry. AT&T had a monopoly on local service, long distance, and the manufacture of all equipment used by
telephone companies, and the breakup was expected to open most of those markets to competition. In the court order
that set the terms of the breakup, the capital structures of the surviv- ing companies were specified and much
attention was given to the increased competi- tion telephone companies could expect in the future. Do you think the
optimal capital structure after the breakup was the same as the pre-breakup optimal capital structure? Explain your
position.
The word optimal is the key, if a company is providing a good service and people are not complaining and all equipment is
being manufactured and used by the same company meaning that they are an all inclusive self-sustaining business
providing services then no, I do not believe that the breakup of this company was optimal after it became several different
other smaller entities trying to provide the same service. I normally go with the motto, if it's not broke then don't try to fix
it. After some research, I was able to conclude that the company broke into approximately 7 different other firms and then
broke into even more subsidiaries from the those 7 firms. AT&T has lost 70% or more of its business and had to
restructure the company based on the smaller amount of ownership that it was left with after the court order.

Problems
14-5 FINANCIAL LEVERAGE EFFECTS Firms HL and LL are identical except for their financial leverage ratios and
the interest rates they pay on debt. Each has $20 million in invested capital, has $4 million of EBIT, and is in the 40%
federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt,
whereas LL has a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock
in its capital structure.
a. Calculate the return on invested capital (ROIC) for each firm.
b. Calculate the return on equity (ROE) for each firm.
c. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt-to- capital ratio from
30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROE for
LL.
5) ROIC = Return on Invested Capital
a. ROIC = EBIT(1 – T) / Total Capital
= $4,000,000 (0.75) / $20,000,000
= 15%
b. LL: 30% Debt
EBIT – Interest = EBT
$4,000,000 – 600,000
EBT = $3,400,000
EBT – Tax = Net Income
EBT = $3,400,000 – 850,000 → 0.25($3,400,000)
= $2,550,000
ROI = NE/Equity
$2,550,000/($20,000,000 * 0.7) = 18.21%
HL: 50% Debt
EBIT – Interest = EBT
= $4,000,000 - $1,200,000
EBT = $2,800,000
EBT – Tax = Net Income
= $2,800,000 - $700,000
= $2,100,000
ROI = NE/Equity
ROE = $2,100,000 / (20,000,000 * 0.5) = 21.0%

c. LL Debt 60%
EBET – Interest = EBT
= $4,000,000 – 1,800,000 → 12,000,000 * 0.15
EBT – Tax = Net Income
= $2,200,000 – 550,000
= 1,650,000
ROE = NI / Equity
$1,650,000 / (20,000,000 * 0.40) = 20.63%

14-6 BREAK-EVEN ANALYSIS The Warren Watch Company sells watches for $26, fixed costs are $155,000, and
variable costs are $13 per watch.
1. What is the firm’s gain or loss at sales of 9,000 watches? At 15,000 watches?
2. What is the break-even point? Illustrate by means of a chart.
3. What would happen to the break-even point if the selling price was raised to $33? What is the significance of
this analysis?
4. What would happen to the break-even point if the selling price was raised to $33 but variable costs rose to
$24 a unit?
a.
9,000 Units 15,000 units
Sales $ 234,000 $ 390,000
Fixed Costs $ 155,000 $ 155,000
Variable Costs $ 117,000 $ 195,000
Total Costs $ 272,000 $ 350,000
Gain (Loss) $ (38,000) $ 40,000
b. QBE = F / (P -V) → $155,000 (26 – 13) = 11,923 Units
c. QBE = $155,000 / ($33 - $13) = 7,750 units
d. QBE = $155,000 / ($33 - $24 ) = 17,222 units
14-8 HAMADA EQUATION Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its
current capital structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should use
more debt. The risk-free rate, rRF, is 4%; the market risk premium, RPM, is 5%; and the firm’s tax rate is 40%.
Currently, SSC’s cost of equity is 12%, which is determined by the CAPM. What would be SSC’s estimated cost of
equity if it changed its capital structure to 40% debt and 60% equity?
14 -8
Step 1: Find Current Beta
Rs = rRF + (ru – rRF) * b
 12% = 4% + (5%) b
8% = 5% * b
b = 1.6

Step 2: Unlever Beta

Bu = bL / [1 + (1 – T) (D/E)]
= 1.6 / [ 1 + (1 – 0.25) (0.25/0.75)]
= 1.28

Step 3: Find new Beta

bL = bu [1 + (1 – T) (D/E)]
= 1.28 [1 + (1 – 0.25) (0.4/0.6)
= 1.92

Step 4: New Cost of Equity

Rs = rRF + (ru – rRF) * b
= 4% + 5% (1.92)
= 13.60%

14-9 RECAPITALIZATION Tartan Industries currently has total capital equal to $4 million, has zero debt, is in the
40% federal-plus-state tax bracket, has a net income of $1 million, and distributes 40% of its earnings as dividends.
Net income is expected to grow at a constant rate of 3% per year, 200,000 shares of stock are outstanding, and the
current WACC is 12.30%.
The company is considering a recapitalization where it will issue $2 million in debt and use the proceeds to
repurchase stock. Investment bankers have estimated that if the company goes through with the recapitalization, its
before-tax cost of debt will be 10% and its cost of equity will rise to 15.5%.
a. What is the stock’s current price per share (before the recapitalization)?
b. Assuming that the company maintains the same payout ratio, what will be its stock price following the
recapitalization? Assume that shares are repurchased at the price calculated in part a.
14-9 Recapitalization
a. P0 = D1 / (rs -g)
Dividends = 0.4 * $1,000,000
= $400,000
Dividends per share = $400,000 / 200,000 shares outstanding = $2 per share
D1 = Last Dividend
So D0 = $2
D1 = D0 (1 + g)
$2 (1 + 0.03)
D1 = $2.06
P0 = D1 / (rs -g)
= $2.06 / (0.123 – 0.03)
= $22.15

b. Step 1: Evaluate EBIT before recap

EBIT – Tax = Net Income
EBIT (1 – T) = Net Income
EBIT ( 1- 0.25) = $1,000,000
EBIT = $1,000,000 / 0.75 = $1.333,333

Step 2: Net Income after Recap

EBIT – Interest = EBT → EBT – Tax = Net Income
$1,333,333 – $200,000 [$2,000,000 * 0.10]
Net Income = $850,000
 Step 3: # of shares outstanding after recap
Initially 200,000 shares outstanding
200,000 – ($2,000,000/$22.15) = 109,707 Shares Outstanding after recap

Step 4: Calculate D1 after recap

D0 = 0.4 * ( $850,000 / 109,707 shares)
= $3.0992

Step 5: Price after recap

P0 = D1 / (rs -g)
= ($3.0992 * 1.03) / (0.155 – 0.03)
= $25.54
14-10 BREAKEVEN AND OPERATING LEVERAGE
1. Given the following graphs, calculate the total fixed costs, variable costs per unit, and sales price for Firm A.
Firm B’s fixed costs are $120,000, its variable costs per unit are $4, and its sales price is $8 per unit.
2. Which firm has the higher operating leverage at any given level of sales? Explain.
3. At what sales level, in units, do both firms earn the same operating profit?

14-10 Breakeven And Operating Leverage

a. Firm A
a. FC = $80,000
b. VC/Unit = (Breakeven Sales – Fixed Costs) / Breakeven Units
i. ($200,000 - $80,000) / 25,000 = $4.80 / unit
c. Selling Price per Unit = Breakeven sales / Breakeven units
i. $200,000 / 25,000 = $8/unit
ii. **Obviously has to be higher than VC to Breakeven**
b. Firm B
a. FC = $120,000
b. VC/Unit = ($240,000 – 120,000) / 30,000
i. $4 per unit
c. Selling Price per Unit
i. $240,000 / 30,000 = $8 per unit
c. Operating Profit = P*Q – FC – VC*Q
a. Firm A
i. $8X - $80,000 - $4.80X
b. Firm B
i. $8X - $120,000 - $4X
c. 8X – 80,000 - $.80X = 8X – 120,000 – 4X
i. -0.8X = $40,000
ii. X = 50,000 Units
14-11 RECAPITALIZATION Currently, Forever Flowers Inc. has a capital structure consisting of 25% debt and 75%
equity. Forever’s debt currently has a 7% yield to maturity. The risk-free rate (rRF) is 6%, and the market risk premium
(rM – rRF) is 7%. Using the CAPM, Forever estimates that its cost of equity is currently 14.5%. The company has a 40%
tax rate.
a. What is Forever’s current WACC?
b. What is the current beta on Forever’s common stock?
c. What would Forever’s beta be if the company had no debt in its capital structure?
(That is, what is Forever’s unlevered beta, bU?)
Forever’s financial staff is considering changing its capital structure to 40% debt and 60% equity. If the company
went ahead with the proposed change, the yield to maturity on the company’s bonds would rise to 10.5%. The
proposed change will have no effect on the company’s tax rate.
d. What would be the company’s new cost of equity if it adopted the proposed change in capital structure?
e. What would be the company’s new WACC if it adopted the proposed change in capi- tal structure?
f. Based on your answer to part e, would you advise Forever to adopt the proposed change in capital structure?
Explain.
14-11
a. WACC = wdrd ( 1 – T) + wsrs
= (0.25)(7%)(1 – 0.25) + (0.75)(14.5%)
= 12.1875%
b. Rs = rRF + (rM – rRF) * b
14.5% = 6% + 7% * b
b = 1.2143
c. bL = bu [1 + (1 – t) (D/E)]
1.2143 = bu [ 1+ (1 – 0.25) (0.25/0.25)]
bu = 0.9714
d. bL 40% = 0.9714 [1 + (1 – 0.25)(0.40/0.60)]
= 1.4571
Rs = rRF + (rM – rRF) *b
= 6% + (7% * 1.4571)
= 16.20%
e. WACC = (0.40) (10.5%) (1 – 0.25) + (0.60)(16.20%)
= 12.87%
f. Not make a change to Capital Structure because we’re trying to Maximize firm value, which comes from
Minimizing WACC Value.

14-12 BREAKEVEN AND LEVERAGE Wingler Communications Corporation (WCC) produces premium stereo
headphones that sell for $28.80 per set, and this year’s sales are expected to be 450,000 units. Variable production
costs for the expected sales under present production methods are estimated at $10,200,000, and fixed production
(operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 8%. There
are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%,
and WCC is in the 40% federal-plus-state tax bracket.
The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per
unit would decline by 20%. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could
raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares of common stock at
$30 per share.
a. What would be WCC’s EPS (1) under the old production process, (2) under the new process if it uses debt, and (3)
under the new process if it uses common stock?
b. At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it
with debt or with stock? {Hint: V = variable cost per unit = $8,160,000/450,000, and EPS = [(PQ – VQ – F – I)(1 – T)]/N.
Set EPSStock = EPSDebt and solve for Q.}
c. At what unit sales level would EPS = 0 under the three production/financing setups—that is, under the old plan,
the new plan with debt financing, and the new plan with stock financing? (Hint: Note that Vold = $10,200,000/450,000,
and use the hints for part b, setting the EPS equation equal to zero.)
14-12
a. Old Process:
Sales 12,960,000
– VC 10,200,000
– FC 1,560,000
EBIT 1,200,000
– Interest 384,000 [.08 * 4,800,000]
EBT 816,000
– Tax 209,000
Net Income 612,000

EPS = NI / Shares Outstanding

= 612,000 / 2??

With new investment:

Debt Equity
Sales 12,960,000 12,960,000
– VC 8,160,000 8,160,000 [10,200,000 * 0.80]
– FC 1,800,000 1,800,000
EBIT 3,000,000 3,000,000
– Interest 1,104,000 * 384,000
EBT 1,896,000 2,616,000
– Tax (25%) 474,000 654,000
Net Income 1,422,000 1,962,000

* =0.08(4,800,000) + 0.10(7,200,000) = $1,104,000

EPS debt = $1,422,000 / 240,000 = $5.93

EPS equity = $1,962,000/480,000 = $4.09

b. EPS = [(PQ – VQ – F – I)(1 – T)] / N

EPS debt = [(28.80*Q – 18.133*Q – 1,800,000 – 1,104,000) (1 – 0.25)] / 240,000 = [(28.80*Q –

18.133*Q – 1,800,000 –384,000)] / 480,000 = EPS equity

$10.667 *Q = $3,624,000

Q = 339,750 units

c. EPS old = [[(28.80*Q – 18.133*Q – 1,560,000 – 384,000) (1 – 0.25)] / 240,000 ] = $0

4.6Q = 1,458,000
Q = 316,957

EPS debt = [[(28.80*Q – 18.133*Q – 1,800,000 – 1,104,000) (1 – 0.25)] / 240,000 ] = $0

$8Q = $2,178,000
Q = 272,250

EPS equity = [[(28.80*Q – 18.133*Q – 1,800,000 – 1,384,000) (1- 0.25)] / 480,000 ] = $0

$8Q = 1,638,000
Q = 204,750
14-13 FINANCING ALTERNATIVES The Severn Company plans to
raise a net amount of $270 million to finance new equipment in
early 2019. Two alternatives are being considered: Common stock
may be sold to net $60 per share, or bonds yielding 12% may be
issued. The balance sheet and income statement of the Severn
Company prior to financing are as follows:
Assuming that EBIT equals 10% of sales, calculate earnings per
share (EPS) under the debt financing and the stock financing
alternatives at each possible sales level.

CHAPTER 15
15-1 Discuss the pros and cons of having the directors formally announce a firm’s future dividend policy.

15-1 The biggest advantage of having an announced dividend policy is that it would reduce investor uncertainty, and
reductions in uncertainty are generally associated with lower capital costs and higher stock prices, other things being
equal. The disadvantage is that such a policy might decrease corporate flexibility. However, the announced policy would
possibly include elements of flexibility. On balance, it would appear desirable for directors to announce their policies.

15-2 The cost of retained earnings is less than the cost of new outside equity capital. Consequently, it is totally
irrational for a firm to sell a new issue of stock and to pay cash dividends during the same year. Discuss the meaning
of those statements.
15-2 While it is true that the cost of outside equity is higher than that of retained earnings, it is not necessarily irrational
for a firm to pay dividends and sell stock in the same year. The reason is that if the firm has been paying a regular
dividend, and then cuts it in order to obtain equity capital from retained earnings, there might be an unfavorable effect on
the firm’s stock price. If investors lived in the world of certainty and rationality postulated by Miller and Modigliani, then
the statement would be true, but it is not necessarily true in an uncertain world.

15-3 Would it ever be rational for a firm to borrow money in order to pay cash dividends? Explain.

15-3 Logic suggests that stockholders like stable dividends—many of them depend on dividend income, and if dividends
were cut, this might cause serious hardship. If a firm’s earnings are temporarily depressed or if it needs a substantial
amount of funds for investment, then it might well maintain its regular dividend using borrowed funds to tide it over until
things returned to normal. Of course, this could not be done on a sustained basis—it would be appropriate only on
relatively rare occasions.

15-4 Modigliani and Miller (MM), on the one hand, and Gordon and Lintner (GL), on the other hand, have
expressed strong views regarding the effect of dividend policy on a firm’s cost of capital and value.
a. In essence, what are MM’s and GL’s views regarding the effect of dividend policy on the cost of capital and stock
prices?
b. How could MM use the information content, or signaling, hypothesis to counter their opponents’ arguments? If
you were debating MM, how would you counter them?
c. How could MM use the clientele effect concept to counter their opponents’ arguments? If you were debating
MM, how would you counter them?
15-4
a. MM argue that dividend policy has no effect on rs, thus no effect on firm value and cost of capital. On the other hand, GL
argue that investors view current dividends as being less risky than potential future capital gains. Thus, GL claim that rs is
inversely related to dividend payout.

b. MM could claim that tests which show that increased dividends lead to increased stock prices demonstrate that
dividend increases are causing investors to revise earnings forecasts upward, rather than cause investors to lower rs.
MM’s claim could be countered by invoking the efficient market hypothesis. That is, dividend increases are built into
expectations and dividend announcements could lower stock price, as well as raise it, depending on how well the
dividend increase matches expectations. Thus, a bias towards price increases with dividend increases supports GL.

c. Since there are clients who prefer different dividend policies, MM could argue that one policy is as good as another. But,
if the clienteles are of differing sizes or economic means, the clienteles might not be equal, and one dividend policy could
be preferential to another.

15-5 How would each of the following changes tend to affect aggregate (i.e., the average for all corporations)
payout ratios, other things held constant? Explain your answers.
d. An increase in the personal income tax rate
e. Aliberalizationofdepreciationforfederalincometaxpurposes—thatis,fastertaxwrite-offs
f. An increase in interest rates
g. An increase in corporate profits
h. A decline in investment opportunities
i. Permission for corporations to deduct dividends for tax purposes as they now deduct interest expense
j. A change in the Tax Code so that realized and unrealized long-term capital gains in any year are taxed at the
same rate as ordinary income

15-5
a. From the stockholders’ point of view, an increase in the personal income tax rate would make it more desirable for a
firm to retain and reinvest earnings. Consequently, an increase in personal tax rates should lower the aggregate payout
ratio.

b. If the depreciation allowances were raised, cash flows would increase. With higher cash flows, payout ratios would tend
to increase. On the other hand, the change in tax-allowed depreciation charges would increase rates of return on
investment, other things being equal, and this might stimulate investment, and consequently reduce payout ratios. On
balance, it is likely that aggregate payout ratios would rise, and this has in fact been the case

c. If interest rates were to increase, the increase would make retained earnings a relatively attractive way of financing
new investment. Consequently, the payout ratio might be expected to decline. On the other hand, higher interest rates
would cause rd, rs, and firms’ MCCs to rise—that would mean that fewer projects would qualify for capital budgeting and
the residual would increase (other things constant), hence the payout ratio might increase.

d. A permanent increase in profits would probably lead to an increase in dividends, but not necessarily to an increase in
the payout ratio. If the aggregate profit increase were a cyclical increase that could be expected to be followed by a
decline, then the payout ratio might fall, because firms do not generally raise dividends in response to a short-run profit
increase.

e. If investment opportunities for firms declined while cash inflows remained relatively constant, an increase would be
expected in the payout ratio.
f. Dividends are currently paid out of after-tax dollars, and interest charges from before-tax dollars. Permission for firms
to deduct dividends as they do interest charges would make dividends less costly to pay than before and would thus tend
to increase the payout ratio.

g. This change would make capital gains less attractive and would lead to an increase in the payout ratio.

15-6 One position expressed in the financial literature is that firms set their dividends as a residual after using
income to support new investment.
a. Explain what a residual dividend policy implies, illustrating your answer with a table showing how different
investment opportunities can lead to different dividend payout ratios.
b. Think back to Chapter 14 where we considered the relationship between capital structure and the cost of capital.
If the WACC-versus-debt-ratio plot was shaped like a sharp V, would this have a different implication for the
importance of setting dividends according to the residual policy than if the plot was shaped like a shallow bowl
(a flattened U)?

15-6
a. The residual dividend policy is based on the premise that, since new common stock is more costly than retained
earnings, a firm should use all the retained earnings it can to satisfy its common equity requirement. Thus, the dividend
payout under this policy is a function of the firm’s investment opportunities.

b. Yes. A shallower plot implies that changes from the optimal capital structure have little effect on the firm’s cost of
capital, hence value. In this situation, dividend policy is less critical than if the plot were V-shaped.

15-8 What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see
your company declare a 100% stock dividend or a two-for-one split? Assume that either action is feasible.

15-8 The difference is largely one of accounting. In the case of a split, the firm simply increases the number of shares and
simultaneously reduces the par or stated value per share. In the case of a stock dividend, there must be a transfer from
retained earnings to capital stock. For most firms, a 100% stock dividend and a 2-for-1 stock split accomplish exactly the
same thing; hence, investors may choose either one.

15-9 Most firms like to have their stock selling at a high P/E ratio, and they also like to have extensive public
ownership (many different shareholders). Explain how stock dividends or stock splits may help achieve those goals.

It is sometimes argued that there is an optimum price for a stock; that is, a price at which WACC will be minimized, giving
rise to a maximum price for any given earnings. If a firm can use stock dividends or stock splits to keep its shares selling
at this price (or in this price range), then stock dividends and/or splits will have helped maintain a high P/E ratio. Others
argue that stockholders simply like stock dividends and/or splits for psychological or some other reasons. If stockholders
do like stock dividends, using them would have the effect of keeping P/E ratios high. Finally, it has been argued that
increases in the number of shareholders accompany stock dividends and stock splits. One could, of course, argue that no
causality is contained in this relationship. In other words, it could be that growth in ownership and stock splits is a
function of yet another variable.

15-10 Indicate whether the following statements are true or false. If the statement is false, explain why.
a. If a firm repurchases its stock in the open market, the shareholders who tender the stock are subject to capital
gains taxes.
b. If you own 100 shares in a company’s stock and the company’s stock splits two-for- one, you will own 200 shares
in the company following the split.
c. Some dividend reinvestment plans increase the amount of equity capital available to the firm.
d. The Tax Code encourages companies to pay a large percentage of their net income in the form of dividends.
e. If your company has established a clientele of investors who prefer large dividends, the company is unlikely to
adopt a residual dividend policy.
f. If a firm follows a residual dividend policy, holding all else constant, its dividend payout will tend to rise
whenever the firm’s investment opportunities improve.
15-10
a. True. When investors sell their stock they are subject to capital gains taxes.
b. True. If a company’s stock splits 2 for 1, and you own 100 shares, then after the split you will own 200 shares.
c. True. Dividend reinvestment plans that involve newly issued stock will increase the amount of equity capital available
to the firm.
d. False. The Tax Code, through the tax deductibility of interest, encourages firms to use debt and thus pay interest to
investors rather than dividends, which are not tax deductible. In addition, due to the deferral of capital gains taxes until a
capital asset is sold, the Tax Code encourages investors in high tax brackets to prefer firms who retain earnings rather
than those that pay large dividends.
e. True. If a company’s clientele prefers large dividends, the firm is unlikely to adopt a residual dividend policy. A
residual dividend policy could mean low or zero dividends in some years, which would upset the company’s developed
clientele.
f. False. If a firm follows a residual dividend policy, all else constant, its dividend payout will tend to decline whenever the
firm’s investment opportunities improve

15-11 What is meant by catering theory, and how might it impact a firm’s dividend policy?

15-11 Catering theory suggests that investors’ preference for dividends varies over time and that corporations adapt
dividend policy to ‘cater’ to the current desires of investors. Consequently, corporate managers are more likely to initiate
dividends when dividend-paying stocks are in favor with investors and are more likely to omit dividends when investors
prefer capital gains.

PROBLEMS

15-1 RESIDUAL DIVIDEND MODEL Altamonte Telecommunications has a target capital structure that consists of 45%
debt and 55% equity. The company anticipates that its capital bud- get for the upcoming year will be $1,000,000. If
Altamonte reports net income of $1,200,000 and it follows a residual dividend payout policy, what will be its
dividend payout ratio?

15-1 Math Problem

Dividends = NI – [(Target Equity Ratio )(Total Capital Budget)]
= $1,200,000 – [(0.55) ($1,000,000)]
= $650,000
Dividend Payout Ratio = Dividends / Net Income
= 650,000 / 1,200,000 = 54.17%

15-2 STOCK SPLIT Emergency Medical’s stock trades at $145 a share. The company is contemplating a 3-for-2 stock
split. Assuming that the stock split will have no effect on the market value of its equity, what will be the company’s
stock price following the stock split?

15-2 Stock Split

Old Price divided by stock split = New Price
$145/ (3/2) = Pnew
Pnew = $96.67

Regular split VS Reverse split: regular split price should go down; reverse price should go up

15-3 STOCK REPURCHASES Gamma Industries has net income of $3,800,000, and it has 1,490,000 shares of common
stock outstanding. The company’s stock currently trades at $67 a share. Gamma is considering a plan in which it will
use available cash to repurchase 10% of its shares in the open market at the current $67 stock price. The repurchase is
expected to have no effect on net income or the company’s P/E ratio. What will be its stock price following the stock
repurchase?

15-3
Current EPS = 3,800,000 / 1,490,000 = $2.55
P/E Ratio = 67/2.55 = 26.77
Share repurchased = 0.10 * 1,490,000 = 140,000

15-4 STOCK SPLIT After a 5-for-l stock split, Tyler Company paid a dividend of $1.15 per new share, which
represents a 7% increase over last year’s pre-split dividend. What was last year’s dividend per share?

15-4
Pre-Split Equivalent = 1.15 * (5/1) = $5.75
5.75 = 1.07 (D0)
D0 = $5.37

15-5 EXTERNAL EQUITY FINANCING Coastal Carolina 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 45%
with a $20 million investment in plant and machinery. The firm wants to maintain a 35% debt level in its capital
structure. It also wants to maintain its past dividend policy of distributing 55% of last year’s net income. In 2018, net
income was $5 million. How much external equity must Coastal Carolina seek at the beginning of 2019 to expand
capacity as desired? Assume that the firm uses only debt and common equity in its capital structure.

15-5 **KNOW** How to solve for a diff component, moving formulas around, Find how much equity you need.
Equity Required = Equity % * Capital Investment
= (1 – 0.35) * $20,000,000
= $13,000,000 is the 65% in Equity Funding
Dividend Payout = 0.55 * 5,000,000 = $2,750,000
Retained earnings= Net income (1 –Payout ratio)
= $5,000,000 – (1-0.55)
= $2,250,000
External Equity Needed = Equity Required – Retained Earnings
= 13,000,000 – 2,250,000
= 10,750,000

15-6 RESIDUAL DIVIDEND MODEL Walsh Company is considering three independent projects, each of which
requires a $4 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 = 19%
Project M (medium risk): Cost of capital = 12% IRR = 13%
Project L (low risk): Cost of capital = 9% IRR = 8%
Note that the projects’ costs of capital vary because the projects have different levels of risk. The company’s optimal
capital structure calls for 40% debt and 60% common equity, and it expects to have net income of $7,500,000. If Walsh
establishes its dividends from the residual dividend model, what will be its payout ratio?

15-6 *Don’t need to draw table but know residual dividend policy* 15-3A Example in Book
a. Anything left over after budget met → everything leftover is paid out as dividends
b. Capital gains taxed at lower rate bc: Constant cash flow ??

Residual model ratio affect dividend ratio: Anything after budget is met
Using more debt = using more equity = more equity left over
So High leverage = More payout ratio, RISKIER Firm

15-7 DIVIDENDS Brooks Sporting Inc. is prepared to report the following 2018 income statement (shown in
thousands of dollars).
Prior to reporting this income statement, the company wants to determine its annual dividend. The company has
320,000 shares of common stock outstanding, and its stock trades at $37 per share.
1. The company had a 25% dividend payout ratio in 2017. If Brooks wants to maintain this payout ratio in
2018, what will be its per-share dividend in 2018?
2. If the company maintains this 25% payout ratio, what will be the current dividend yield on the company’s
stock?
3. The company reported net income of $1.35 million in 2017. Assume that the number of shares outstanding
has remained constant. What was the company’s per-share dividend in 2017?
4. As an alternative to maintaining the same dividend payout ratio, Brooks is considering maintaining the
same per-share dividend in 2018 that it paid in 2017. If it chooses this policy, what will be the company’s
dividend payout ratio in 2018?
5. 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.

15-9 ALTERNATIVE DIVIDEND POLICIES In 2017, Keenan Company paid dividends totaling $3,600,000 on net
income of $10.8 million. Note that 2017 was a normal year and that for the past 10 years, earnings have grown at a
constant rate of 10%. However, in 2018, 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 2018
level of earnings growth because the high 2018 earnings level is attributable to an exceptionally profitable new
product line introduced that year. After 2018, 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 2018 assuming that it follows each of the fol- lowing policies:
1. Its 2018 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
2. It continues the 2017 dividend payout ratio.
3. It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt
and 60% with common equity).
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.

CHAPTER 21
Types of Mergers : Specifically, Synergy

Hastings Corporation is interested in acquiring Visscher Corporation. Assume that the risk- free rate of interest is 4%,
and the market risk premium is 5%.

21-1 VALUATION Visscher currently expects to pay a year-end dividend of $1.99 a share (D1 = $1.99). Visscher’s
dividend is expected to grow at a constant rate of 5% a year, and its beta is 0.8. What is the current price of Visscher’s
stock?

21-1
P0 = D / (rs – g)
D1 = 1.99
G = 5%
B = 0.08

P0 = 1.99 / (.08 – 0.05)

P0 = $66.33

21-2 Merger Valuation Hastings estimates that if it acquires Visscher, the year-end dividend will remain at $1.99 a
share, but synergies will enable the dividend to grow at a constant rate of 7% a year (instead of the current 5%).
Hastings also plans to increase the debt ratio of what would be its Visscher subsidiary; the effect of this would be to
raise Visscher’s beta to 1.05. What is the per-share value of Visscher to Hastings Corporation?

21-2
Rs = rRF + MRP (b)
Rs = 4% + 5% * (1.05)
Rs = 9.25%

P0 = D1 / (rs – g)
P0 = 1.99 / .0925 - .07)
P0 = $88.44

21-3 Merger bid On the basis of your answers to problems 21-1 and 21-2, if Hastings were to acquire Visscher, what
would be the range of possible prices it could bid for each share of Visscher common stock?

21-3 *Won’t have one this easy*

Range = $66.33 – $88.44

21-4 merger analySiS Aubey Appliance Corporation is considering a merger with the Velmore Vacuum Company.
Velmore is a publicly traded company, and its current beta is 1.30. Velmore has been barely profitable, so it has paid
an average of only 20% in taxes during the last several years. In addition, it uses little debt, having a debt ratio of just
25%.

If the acquisition were made, Aubey would operate Velmore as a separate, wholly owned subsidiary. Aubey would
pay taxes on a consolidated basis, and the tax rate would therefore increase to 35%. Aubey also would increase the
debt capitalization in the Velmore subsidiary to 40% of assets, which would increase its beta to 1.47. Aubey’s
acquisition department estimates that Velmore, if acquired, would produce the following cash flows to Aubey’s
shareholders (in millions of dollars):

These cash flows include all acquisition effects. Aubey’s cost of equity is 14%, its beta is 1.0, and its cost of debt is
10%. The risk-free rate is 9%.

1. What discount rate should be used to discount the estimated cash flows? (Hint: Use Aubey’s r s to determine
the market risk premium.)
2. What is the dollar value of Velmore to Aubey?
 3. Velmore has 1.5 million common shares outstanding. What is the maximum price per share that Aubey
should offer for Velmore? If the tender offer is accepted at this price, what will happen to Aubey’s stock
price?

21-4
a. Rs = rRF + MRP (b)
14% = 9% + MRP (1.0)
MRP = 5%

Rs = 9% + 5% * (1.54)
Rs = 16.70%

b. 0____________1_________2________3________4_____________5
1.25 1.45 1.65 1.85 1.85(1.06) =1.961
HV=?
HV4 = CF5 / (rs – g)
= 1.961 / (0.167 – 0.06)
= $18.33
Discount rate = 16.70%

EXCEL: =NPV( Discount Rate,

c. Max Price = Value / $ of Shares

= $14.05 / 1.5
= $9.37

21-5 CAPITAL BUDGETING ANALYSIS The Stanton Stationery Shoppe wants to acquire The Carlysle Card Gallery
for $450,000. Stanton expects the merger to provide incremental earnings of about $70,000 a year for 10 years. Carol
Stanton has calculated the marginal cost of capital for this investment to be 8%. Conduct a capital budgeting analysis
for Stanton to determine whether she should purchase The Carlysle Card Gallery.

21-5
EXCEL: Solving for NPV
0________________________1_________2……._____________10
-450,000 70,000 70,000…… 70,000

CF0 = -450,000
CF 1-10 = 70,000
I/Y = 8
NPV = ? = $19,705.70