15-1 RESIDUAL DIVIDEND MODEL Axel Telecommunications has a target capital structure that consists of 70% debt and 30% equity. The company anticipates that its capital budget for the upcoming year will be $3,000,000. If Axel reports a net income of $2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio? 15-2 STOCK SPLIT Gamma Medicals 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 market value of its equity, what will be the companys stock price following the stock split? 15-3 STOCK REPURCHASES Beta Industries has a net income of $2,000,000, and it has 1,000,000 shares of common stock outstanding. The companys stock currently trades at $32 a share. Beta is considering a plan in which it will use available cash to repurchase 20% of its shares in the open market. The repurchase is expected to have no effect on net income or the companys P/E ratio. What will be Betas stock price following the stock repurchase? Intermediate Problems 46 15-4 STOCK SPLIT After a 5-for-1 stock split, Strasburg Company paid a dividend of $0.75 per new share, which represents a 9% increase over last years pre-split dividend. What was last years dividend per share? 15-5 EXTERNAL EQUITY FINANCING Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management Chapter 15 Distributions to Shareholders: Dividends and Share Repurchases 481 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 years 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. 15-6 RESIDUAL DIVIDEND MODEL 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 costs of capital vary because the projects have different levels of risk. The companys optimal capital structure calls for 50% debt and 50% common equity. Welch expects to have a net income of $7,287,500. If Welch establishes its dividends from the residual model, what will be its payout ratio? Challenging Problems 79 15-7 DIVIDENDS Bowles Sporting Inc. is prepared to report the following income statement (shown in thousands of dollars) for the year 2009. 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 2008. If Bowles wants to maintain this payout ratio is 2009, what will be its per-share dividend in 2009? b. If the company maintains this 40% payout ratio, what will be the current dividend yield on the companys stock? c. The company reported a net income of $1.5 million in 2008. Assume that the number of shares outstanding has remained constant. What was the companys per-share dividend in 2008? d. As an alternative to maintaining the same dividend payout ratio, Bowles is considering maintaining the same per-share dividend in 2009 that it paid in 2008. If it chooses this policy, what will be the companys dividend payout ratio is 2009? 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? 15-8 ALTERNATIVE DIVIDEND POLICIES 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 companys target capital structure, the firm has $10 million in assets, of which 40% is funded by debt. Assume that the firms 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. a. Based on that information, what long-run growth rate can the firm be expected to maintain? (Hint: g Retention rate ROE.) b. What is the stocks required return? 482 Part 5 Capital Structure and Dividend Policy c. If the firm changed its dividend policy and paid an annual dividend of $1.50 per share, financial analysts would predict that the change in policy will have no effect on the firms stock price or ROE. Therefore, what must be the firms new expected long-run growth rate and required return? 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 firms current market capitalization? (Hint: Remember that market capitalization P0 number of shares outstanding.) e. If the plan in Part d is implemented, how many new shares of stock will be issued and by how much will the companys earnings per share be diluted? 15-9 ALTERNATIVE DIVIDEND POLICIES In 2008, Keenan Company paid dividends totalling $3,600,000 on a net income of $10.8 million. Note that 2008 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2009, 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 2009 level of earnings growththe high 2009 earnings level is attributable to an exceptionally profitable new product line introduced that yearand the company will return to its previous 10% growth rate. Keenans target capital structure is 40% debt and 60% equity. a. Calculate Keenans total dividends for 2009 assuming that it follows each of the following policies: (1) Its 2009 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. (2) It continues the 2008 dividend payout ratio. (3) It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt and 60% with common equity). (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 policy. b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer. c. Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2009 and to have the dividend grow at 10% after 2009. The stocks total market value is $180 million. What is the companys cost of equity? d. What is Keenans long-run average return on equity? [Hint: g Retention rate ROE (1.0 Payout rate)(ROE).] e. Does a 2009 dividend of $9,000,000 seem reasonable in view of your answers to Parts c and d? If not, should the dividend be higher or lower? Explain your answer.