538 CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases
c.If a 60 percent payout ratio is maintained for the foreseeable future, what is your estimate of
the present market price of the common stock? How does this compare with the market
price that should have prevailed under the assumptions existing just before the news about
the founder’s retirement? If the two values of P 0 are different, comment on why.
Problems
Axel Telecommunications has a target capital structure that consists of 70 percent debt and
30percent equity. The company anticipates that its capital budget for the upcoming year will be
$3,000,000. If Axel reports net income of $2,000,000 and it follows a residual dividend payout
policy, what will be its dividend payout ratio?
Gamma Medical’s stock trades at $90 a share. The company is contemplating a 3-for-2 stock
split. Assuming that the stock split will have no effect on the total market value of its equity,
what will be the company’s stock price following the stock split?
Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for its patented so-
lar heating system. To meet this demand, management plans to expand production capacity by
40 percent with a $10 million investment in plant and machinery. The firm wants to maintain a
40 percent debt-to-total-assets ratio in its capital structure; it also wants to maintain its past
dividend policy of distributing 45 percent of last year’s net income. In 2002, net income was
$5 million. How much external equity must Northern Pacific seek at the beginning of 2003 to
expand capacity as desired?
Petersen Company has a capital budget of $1.2 million. The company wants to maintain a tar-
get capital structure which is 60 percent debt and 40 percent equity. The company forecasts that
its net income this year will be $600,000. If the company follows a residual dividend policy, what
will be its payout ratio?
The Wei Corporation expects next year’s net income to be $15 million. The firm’s debt ratio is
currently 40 percent. Wei has $12 million of profitable investment opportunities, and it wishes
to maintain its existing debt ratio. According to the residual dividend model, how large should
Wei’s dividend payout ratio be next year?
After a 5-for-1 stock split, the Strasburg Company paid a dividend of $0.75 per new share,
which represents a 9 percent increase over last year’s pre-split dividend. What was last year’s
dividend per share?
The 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 below:
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 varies because the projects have different levels of risk.
The company’s optimal capital structure calls for 50 percent debt and 50 percent common
equity. Welch expects to have net income of $7,287,500. If Welch bases its dividends on the
residual model, what will its payout ratio be?
In 2002 the Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 mil-
lion. 2002 was a normal year, and for the past 10 years, earnings have grown at a constant rate
of 10 percent. However, in 2003, 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 2003 level of earnings growth—the high 2003 earnings level
is attributable to an exceptionally profitable new product line introduced that year—and the
14–8
ALTERNATIVE DIVIDEND
POLICIES
14–7
RESIDUAL DIVIDEND POLICY
14–6
STOCK SPLIT
14–5
DIVIDEND PAYOUT
14–4
RESIDUAL DIVIDEND POLICY
14–3
EXTERNAL EQUITY FINANCING
14–2
STOCK SPLIT
14–1
RESIDUAL DIVIDEND MODEL
534 Distributions to Shareholders: Dividends and Repurchases
