Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock outstanding.
When CMC's founder, who was also its research director and most successful inventor, retired unexpectedly to the South Pacific in late 2007, CMC was left suddenly and permanently with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to replace the founder's contributions to the firm. Previously, CMC found it necessary to plow back most of its earnings to finance growth, which averaged 12% per year. Future growth at a 5% rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects with at least the 14% rate of return required by CMC's stockholders (r_s = 14%) would amount to only $800,000 for 2008 in comparison to a projected $2,000,000 of net income. If the existing 20% dividend payout were continued, retained earnings would be $1.6 million in 2008, but, as noted, investments that yield the 14% cost of capital would amount to only $800,000.
The one encouraging note is that the high earnings from existing assets are expected to continue, and net income of $2 million is still expected for 2008. Given the dramatically changed circumstances, CMC's management is reviewing the firm's dividend policy.
a. Assuming that the acceptable 2008 investment projects would be financed entirely by earnings retained during the year, calculate DPS in 2008, assuming that CMC uses the residual distribution model and pays all distributions in the form of dividends.
b. What payout ratio does your answer to part a imply for 2008?
c. If a 60% 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 P0 are different, comment on why.