FINMAR

Module 3: Distribution to Shareholders

Assigned Problems

BSA-2B
Members:
Rose Mae Galero (Leader)
Darienne Trespeces
Angeline Lucasan
Alfredo Abulencia Jr.

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%

Note that the projects’ cost of capital vary because the projects have different levels of
risk. The company’s optimal capital structure calls for 50% debt and 50% common
equity, and it expects to have net income of $7,287,500. If Welch establishes its
dividends from residual dividend model, what will be its payout ratio?
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)

= $2,787,500

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

= 0.6667 or 66.67%

g = Retention rate x ROE

= 66.67% x 18%

= 12%

b) What is the stock’s required return?

Required Rate of Return =

= 0.06 + 0.12
= 18%
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

= 0.6667

Retention rate = 1 – Dividend payout ratio

= 1 – 0.6667

= 0.3333

g = Retention rate x ROE

= 0.3333 x 0.18

= 5.99% or 6%

Required Rate of Return =

= 0.06 + 0.12
= 18%
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

Market capitalization = Po x No. of shares

= $12.50 x 480,000

= $6,000,000
Total dividend = No. of shares x Dividends per share

= 480,000 shares x $0.75

= $360,000

Rate of dividend to Capitalization rate = Total Dividend/Market Capitalization

= $360,000/$6,000,0 00

= 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.

New Shares of Stock will be issued = Outstanding shares x Capitalization rate

= 480,000 shs. X 6%
= 28,800 shares
New EPS = Net Income/ New Outstanding shares
= 1,080,000/ 508,800 shs.
= $2.12

EPS Diluted = original EPS – new EPS

= $2.25 – $2.12
= $0.13
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.