Fundamentals of Financial Management (Concise 6th Edition)

A-20 Appendix A Solutions to Self-Test Questions and Problems

d. In this case, the company’s net income would be higher by (0.12 – 0.10)

($2,000,000) (1 – 0.35)! $26,000 because its interest charges would be lower.

The new price would be as follows:

P 0! ($1,820,000 ____________________________ #^ $26,000)/308,455

0.17

! $35.20

In the! rst case, in which debt had to be refunded, the bondholders were com-

pensated for the increased risk of the higher debt position. In the second case,

the old bondholders were not compensated; their 10% coupon perpetual bonds

would now be worth $100/0.12! $833.33, or $1,666,667 in total, down from

the old $2 million, or a loss of $333,333. The stockholders would have a gain as

follows:

($35.20 " $34.71)(308,455)! $151,143

This gain would, of course, be at the expense of the old bondholders. (There is

no reason to think that bondholders’ losses would exactly offset stockholders’

gains.)

e. TIE! EBIT____

I

Original TIE! $4,000,000__________

$200,000

! 20 times

New TIE! $4,000,000__________

$1,200,000

! 3.33 times

Chapter 14

a. Projected net income $2,000,000

Less projected capital investments 800,000

Available residual $1,200,000

Shares outstanding 200,000

DPS! $1,200,000/200,000 shares! $6! D 1

b. EPS! $2,000,000/200,000 shares! $10

Payout ratio! DPS/EPS! $6/$10! 60%, or

Total dividends/NI! $1,200,000/$2,000,000! 60%

c. Currently, P 0!

D 1

_____r

s^ " g

! __0.14 $6" 0.06! ____0.08$6! $75.00

Under the former circumstances, D 1 would be based on a 20% payout on $10

EPS, or $2. With rs! 14% and g! 12%, we solve for P 0 :

P 0! _____D^1

rs " g

! __________$2

0.14 " 0.12

! ____$2

0.02

! $100

Although CMC has suffered a severe setback, its existing assets will continue

to provide a good income stream. More of these earnings should be passed on

to the shareholders, as the slowed internal growth has reduced the need for

funds. However, the net result is a 25% decrease in the value of the shares.

d. If the payout ratio was continued at 20%, even after internal investment

opportunities had declined, the price of the stock would drop to $2/(0.14 "

0.06)! $25 rather than $75.00. Thus, an increase in the dividend payout is

consistent with maximizing shareholder wealth.

Because of the diminishing nature of pro! table investment opportunities,

the greater the! rm’s level of investment, the lower the average ROE. Thus,

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