Weeks 1 - 7 Homework Answer Key

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FI516 – WEEK 1 – HOMEWORK ANSWER KEY
Problem 14-10 14-10
a. 1. 2011 Dividends = (1.10)(2010 Dividends) = (1.10)($3,600,000) = $3,960,000 2. 2010 Payout = $3,600,000/$10,800,000 = 0.33 = 33% 2011 Dividends = (0.33)(2009 Net income) = (0.33)($14,400,000) = $4,800,000 (Note: If the payout ratio is rounded off to 33%, 2011 dividends are then calculated as $4,752,000.) 3. Equity financing = $8,400,000(0.60) = $5,040,000 2011 Dividends = Net income - Equity financing = $14,400,000 - $5,040,000 = $9,360,000 All of the equity financing is done with retained earnings as long as they are available. 4. The regular dividends would be 10% above the 2010 dividends: Regular dividends = (1.10)($3,600,000) = $3,960,000. The residual policy calls for dividends of $9,360,000. Therefore, the extra dividend, which would be stated as such, would be: Extra dividend = $9,360,000 - $3,960,000 = $5,400,000. An even better use of the surplus funds might be a stock repurchase.

b. Policy 4, based on the regular dividend with an extra, seems most logical. Implemented properly, it would lead to the correct capital budget and the correct financing of that budget, and it would give correct signals to investors.

Problem 19-6

19-6

a.

Balance Sheet Alternative 1 Total current liabilities Long-term debt Common stock, par $1 Paid-in capital Retained earnings Total claims

Total assets

$800,000

$150,000 -162,500 437,500 50,000 $800,000

Alternative 2 Total current liabilities Long-term debt Common stock, par $1 Paid-in capital Retained earnings Total claims

Total assets

$800,000

$ 150,000 -150,000 450,000 50,000 $ 800,000

Alternative 3 Total current liabilities Long-term debt (8%) Common stock, par $1 Paid-in capital Retained earnings Total claims Plan 1 80,000 162,500 49% Plan 2 80,000 150,000 53%

Total assets b. Number of shares Total shares Percent ownership

$1,300,000 Original 80,000 100,000 80%

$ 150,000 500,000 150,000 450,000 50,000 $1,300,000 Plan 3 80,000 150,000 53%

c. Total assets EBIT Interest EBT Taxes (40%) Net income Number of shares Earnings per share d. Total liabilities TL/TA

Original Plan 1 Plan 2 Plan 3 $ 550,000 $800,000 $800,000 $1,300,000 $ 110,000 $160,000 $160,000 $ 260,000 20,000 0 0 40,000 $ 90,000 $160,000 $160,000 $ 220,000 36,000 64,000 64,000 88,000 $ 54,000 $ 96,000 $ 96,000 $ 132,000 100,000 162,500 150,000 150,000 $0.59 $0.64 $0.88 $0.54 Original $400,000 73% Plan 1 $150,000 19% Plan 2 Plan 3 $150,000 $650,000 19% 50%

e. Alternative 1 results in loss of control (to 49%) for the firm. Under it, he loses his majority of shares outstanding. Indicated earnings per share increase, and the debt ratio is reduced considerably (by 54 percentage points). Alternative 2 results in maintaining control (53%) for the firm. Earnings per share increase, while a reduction in the debt ratio like that in Alternative 1 occurs. Under Alternative 3, there is also maintenance of control (53%) for the firm. This plan results in the highest earnings per share (88 cents), which is an increase of 63% on the original earnings per share. The debt ratio is reduced to 50%. Conclusions. If the assumptions of the problem are borne out in fact, Alternative 1 is inferior to 2, since the loss of control is avoided. The debt-to-equity ratio (after conversion) is the same in both cases. Thus, the analysis must center on the choice between 2 and 3. The differences between these two alternatives, which are illustrated in Parts c and d, are that the increase in earnings per share is substantially greater under Alternative 3, but so is the debt ratio. With its low debt ratio (19%), the firm is in a good position for future growth under Alternative 2. However, the 50% ratio under 3 is not prohibitive and is a great improvement over the original situation. The combination of increased earnings per share and reduced debt ratios indicates favorable stock price movements in both cases, particularly under...
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