Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock outstanding. When CMCs founder, who was also its research director and most successful inventor, retired unexpectedly to the South Pacific in late 2008, 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 founders contributions to the firm.

Previously, CMC found it necessary to plow back most of its earnings to finance growth, which averaged 13.5% per year. Future growth at a 12% 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 CMCs

stockholders (rs = 14%) would amount to only $800,000 for 2009 compared to a projected $2,000,000 of net income.

If the existing 20% dividend payout was continued, retained earnings would be $1.6 million in 2009; but as noted,

investments that yield the 14% cost of capital would amount to only $800,000.

The one encouraging point is that the high earnings from existing assets are expected to continue, and net income of

$2 million is still expected for 2009. Given the dramatically changed circumstances, CMCs management is reviewing

the firms dividend policy.

a. Assuming that the acceptable 2009 investment projects would be financed entirely by earnings retained

during the year and assuming that CMC uses the residual dividend model, calculate DPS in 2009.

b. What payout ratio does your answer to Part (a) imply for 2009?

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 founders retirement? If the two values of P0 are

different, comment on why