3.

Is the size of the capital budget limited by the amount of net income, as Don implies? What is the maximum size that the capital budget can be in 2016 without selling assets or seeking outside financing?

4.

a.Don says the cost of the outside financing is more expensive than the cost of internal financing, due to the flotation costs charged by investment bankers. Given the data you have, what would you say is the firm's cost of internal equity financing?

b.Assume Montgomery can sell bonds priced to yield 13 percent. What is the firm's aftertax cost of debt? (The tax rate is 25 percent.)

c.Given the cost of debt and the cost of internal equity financing, why doesn't Montgomery just borrow the total amount needed to fund the capital budget and the dividend as well?

Montgomery Corporation In January Ild, the bo ard ofdirectors of Montgomery Corporaiion, one of the na1ion's largest retail store chains, was having its regularly scheduled meeting to establish and declare the next quarterly dividend. {Statements for the rm and industry are shown in Figures 1 and 2.} However, this meeting wasn't so regular. One of the directors, Sidney Mable; who was also a vice president in the company and chief nancial ofcer, had brought a guest: Don Jackson, a nancial analyst. Don had spent a considerable amount of time in the nance dep artrnent and more than a few hours in Mr. W ofce developing a proposal concerning the company's dividend policy. He had nally convinced Mr. MEIER to allow him to present his idea to the board. \"Ladies and gentlemen,\" Don began, aer being introduced by Dir. Mobler, \"I'll skip the preliminaries and get right to the point. I think that Montgomery's dividend policy is not in the best interest of the sto clcholders.\" Dbserving the rather chilly stares om around the ro om, he hastened on: \"Now, I don't mean we have a bad policy, or anything like that; it'sjust that lthinl-c we could do an even betterjob ofincreasing our stoclcholders' wealth with a few small changes.\" He paused for effect. \"Let me explainUp to now our policy has been to pay a constant dividend every year, while increasing it occasionally to reect the company's growth in sales and income. The problem is, that policy takes no accomtoftheinvestrnentopporhut'tiaiat the company has fromyear to year. Inoisr words,th.is yearwewill usemost ofournet income to pay the same, or a greater, dividend than last year, even though there might be comp any investments available thatwould pay a much greater return ifwe committed the funds to the rm's investments instead. In effect, the stockholders are being shortchanged: 'Ihey will realize perhaps a 6 percent yield on their investrnentasa result of receiving the dividend, when they could realize a 12 percentorhigherreter as a resultofthe comp any'sretum on its investments. I see this as a serious shortcoming in the management ofthe sto cliholders' Jnds. \"Now, fortunately, correcng this situa1ionis not difcritllyou have to do is adoptwhatis called a residual dividend policy. That is, each year the rm would allocate money from income In those capital spending projects for which the returnthatis, [Ellis greater thanthe costo f capitalny moneythar is not used in the capital budgetwould bepaid ortto the stockholdersinthe form ofdividends. Ln this way the nn would ensure that the stockholders' money is working the hardest way it can for them.\" Figurel Selected nancial data. Montgomery Corp-eraen {in millions. except per share data! 2669 2616 2611 2612 2613 2614 2615 Sales __________________________________________________________ 52135.4 530.0103 535.3320 533.3230 $403153 544.2315 543.0000 Netinceme ................................................ 5 656.1 5 361.2 5 1.3422 5 1.4543 5 1.3633 5 1.3513 5 1366.6 Amemt to preferred dividends ................... 5 16.? 5 21.5 5 16.3 5 22.6 Amemt to common diln'd ends ................... 5 423.1 5 4716.3 5 53?.6 5 636.3 5 633.6 5 643.3 5 ?25.4 Amemtto retained earnings ...................... 5 221.6 5 334.3 5 365.2 5 36?.3 5 642.3 5 636.2 5 352.6 Common shares du'standing ..................... 34?.3 351.4 354.6 361.6 363.1 3T6.6 3763.6 Earnings pershare-[dn average common shares} ................................................................ 5 1.36 5 2.46 5 3. 36 5 4.66 5 3.66 5 3.65 5 4.51 DPS {on averageeemmon shares} ........... 5 1.36 5 1.36 5 1.43 5 1.?6 5 1.?6 5 1.?6 5 1.36 Fayed ratio {DPSJEPSP ........................... 63.434 55.334 33.3% 41.334 43.3% 43.234 43.533 Total retained eamings .............................. 5 1641.2 5 1426.1 5 3.2313 5 3.6336 5 3.6314 516.3316 511.3136 Cash balance ............................................ 5 1.1?6.? 5 1.3616 5 1.5025 5 1365.6 5 2.35.2 5 2.3344 5 3.2.35.6 'DPS {dividends pershareyEPsmarnings pershare} mg madman 2631mm ucw \fMr. r.Illarence Antry, who was also on the board of directors of the Exxon corp oration and no stranger to the world ofcorporate nance, broke in. \"Young man,\" he said dryly, \"your proposal ignores reality. It's not whether the stockholders are theoretically better off that counts, it's what they want. You cannot tell the stockholders you're doing what's best for them by cutting the dividend; the dividend is what they wantNot onlyis that dividend sure moneyin their pockets now, but the fact that it's the same size as last rne, or even higher, is a signal to them that their company is doing well and will connue to do so in the rture. 'lhese decisions can't always be made on the basis ofgoo dloolsing formulas from the back room, you lmow.\" Ms. Barbara Reynolds, who was the head of directors' auditing committee, and somewhat of an accounting expert, agreed with l'vir. Autry. \"That's a good point, Clarence, and one that's well recognized by our competitors, too. Ifyou check, I don't think you'll nd a single one ofthem that's cut their dividend in the last six years, even though their net income may have declined signicantly. Furthermore, the whole argument is meaningless, anyway, because the dividend is not really competing with the capital budget for fundswe don't turn away pro table proj ectsin favor ofpaying the dividend. If there are worthy projects in which we want to invest, and we would rather use our available cash to pay the dividend, then we seek nancing for the investments from outside sources. in a way,we can have our cake and eatittoo.\" She chuckled, pleased at the analogy. Don Jackson, however, was not to be inrnidated so easily. \"Yes, ma'am, what you say is ne,\" he replied, \"and I would respond that competitors are not treang their stockholders fairly, either. Furthermore, you do seek outside nancing occasionally for large projects, but there are two problems associated with. doing it routinely, as you suggest. First, it might be viewed as borrowing, or issuing stock, to pay the dividend, which would cast the company in a very poor light. Second, it's more expensive to nance from outside sources than from inside due to the fees charged by the i'nvestrnentbanker. Therefore, I believe you should exhaust our inside sources o f nancing before turning to the outside.\" Ms. Reynolds held her ground. \"'Ihat's all very well, but it's slt not necessary to cut the dividend in order to fund the capital budget. As a last resort, if the comp any's cash balances were about to be drawn down too low, we could always declare a stock dividend instead of a cash dividend.\" \"Ladies, gentlemen, \"I'vir. Edward Asking, the chairman, intervened, \"your comments are all very perceptive, but we must move on to the business at hand. All those in favor ofchanging to a residual policy, please raise your hand.\