dividend would tre zero but earnings growth would rise to 14 percent. What will be the expected return to the stockholders (assuming the other factors are held constant)? 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? 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? 5. Do you go along with Clarence Autry's comment that it's what the stockholders want that counts, not their total rate of return? Why or why not? Barbara Reynolds suggests that, if cash is needed for the capital budget, a stock dividend could be substituted for the cash dividend. Do you agree? How do you think the stockholders would react? Regardless of their reaction, is the stock dividend an equivalent substitute for the cash dividend? 7. After all is said and done, do you think the firm's dividend policy matters? If so, what do you think Montgomery's policy should be? Montgomery Corporation Figure 1 Selected financial data, Montgomery Corporation (in millions, except per share data) 2010 2011 2012 2013 2014 2015 Sales $27,357.4 $30.019.8 $35,882.9 $38,828.0 $40,715.3 $44.281.5 $48.000.0 Net income............. $ 650.1 $ 861.2 $ 1,342.2 $ 1,454.8 $ 1,303.3 $ 1,351.3 $ 1.700.0 Amount to preferred dividends. - $ 16.7 $ 21.5 $ 16.8 $ 22.6 Amount to common dividends $ 429.1 $ 476.3 $ 537.0 S 630.8 $ 639.0 $ 648.3 $ 725.4 Amount to retained earnings............ $ 221.0 $ 384.9 $ 8052 $ 807.3 $ 642.8 $ 6862 $ 9520 Common shares outstanding 347.9 351.4 354.6 361,6 363.1 376.6 378.0 Earnings por share on average common shares) $ 1.96 $ 2.46 $ 3.80 $ 4.06 $ 3.60 $ 3.65 $ 4.51 DPS (on average common shares)........... $ 1.36 $ 1.36 $ 1.48 $ 1.70 $ 1.76 $ 1.76 $ 1.96 Payout ratio (DPS/EPS)" 69.4% 55.3% 38.9% 41.8% 48.9% 48.2% 43.5% Total retained earnings.. $ 7,0412 7,426.1 $ 8,231.3 $ 9,038.6 $ 9,681.4 $10,367.6 $11,319.6 Cash balance. $ 1.170.7 $ 1,307.6 $ 1,502.5 $ 1.765.0 $ 2.3572 $ 2.9844 $ 3.235.0 "DPS (dividends per share)EPS (earnings per share) -310 one: S Member (relation): Montgomery Corporation 107 the last six years, even though their net income may have declined significantly Furthermore, the whole argument is meaningless, anyway, because the dividend is not really competing with the capital budget for funds we don't turn away profitable projects in favor of paying 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 financing for the investments from outside sources. In a way, we can have our cake and eat it too." She chuckled, pleased at the analogy. Don Jackson, however, was not to be intimidated so easily. "Yes, ma'am, what you say is true," he replied, and I would respond that competitors are not treating their stockholders fairly, either. Furthermore, you do seek outside financing 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 finance from outside sources than from inside due to the fees charged by the investment banker. Therefore, I believe you should exhaust our inside sources of financing before turning to the outside." Ms. Reynolds held her ground. "That's all very well, but it's still not necessary to cut the dividend in order to fund the capital budget. As a last resort, if the company'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, "Mr. 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 of changing to a residual policy, please raise your hand." Case 27 108 Required . Refer to Figure 1. Would you say that Montgomery's policy up to now has been to pay a constant dividend, with occasional increases as the company grows? Refer to Figure 2. What type of dividend policies would you say are being practiced by Montgomery's competitors in the retailing industry? Do you think that any firms are following a residual policy? Calculate the expected return to the common stockholders under the firm's present policy, given an expected dividend next year of $2.10 and a growth rate of 7.1 percent. Montgomery's stock currently sells for $35. (Use the dividend growth model): 2. Expected return (K) +g b. Assume that, if Don Jackson's proposal were adopted, next year's dividend would be zero but earnings growth would rise to 14 percent. What will be the expected return to the stockholders (assuming the other factors are held constant)? 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? 5. Do you go along with Clarence Autry's comment that it's what the stockholders want that counts, not their total rate of return? Why or why not? 6. Barbara Reynolds suggests that, if cash is needed for the capital budget, a stock dividend could be substituted for the cash dividend. Do you agree? How do you think the stockholders would react? Regardless of their reaction is the stock dividend an equivalent substitute for the cash dividend? 7. After all is said and done, do you think the firm's dividend policy matters? If so, what do you think Montgomery's policy should be? dividend would tre zero but earnings growth would rise to 14 percent. What will be the expected return to the stockholders (assuming the other factors are held constant)? 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? 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? 5. Do you go along with Clarence Autry's comment that it's what the stockholders want that counts, not their total rate of return? Why or why not? Barbara Reynolds suggests that, if cash is needed for the capital budget, a stock dividend could be substituted for the cash dividend. Do you agree? How do you think the stockholders would react? Regardless of their reaction, is the stock dividend an equivalent substitute for the cash dividend? 7. After all is said and done, do you think the firm's dividend policy matters? If so, what do you think Montgomery's policy should be? Montgomery Corporation Figure 1 Selected financial data, Montgomery Corporation (in millions, except per share data) 2010 2011 2012 2013 2014 2015 Sales $27,357.4 $30.019.8 $35,882.9 $38,828.0 $40,715.3 $44.281.5 $48.000.0 Net income............. $ 650.1 $ 861.2 $ 1,342.2 $ 1,454.8 $ 1,303.3 $ 1,351.3 $ 1.700.0 Amount to preferred dividends. - $ 16.7 $ 21.5 $ 16.8 $ 22.6 Amount to common dividends $ 429.1 $ 476.3 $ 537.0 S 630.8 $ 639.0 $ 648.3 $ 725.4 Amount to retained earnings............ $ 221.0 $ 384.9 $ 8052 $ 807.3 $ 642.8 $ 6862 $ 9520 Common shares outstanding 347.9 351.4 354.6 361,6 363.1 376.6 378.0 Earnings por share on average common shares) $ 1.96 $ 2.46 $ 3.80 $ 4.06 $ 3.60 $ 3.65 $ 4.51 DPS (on average common shares)........... $ 1.36 $ 1.36 $ 1.48 $ 1.70 $ 1.76 $ 1.76 $ 1.96 Payout ratio (DPS/EPS)" 69.4% 55.3% 38.9% 41.8% 48.9% 48.2% 43.5% Total retained earnings.. $ 7,0412 7,426.1 $ 8,231.3 $ 9,038.6 $ 9,681.4 $10,367.6 $11,319.6 Cash balance. $ 1.170.7 $ 1,307.6 $ 1,502.5 $ 1.765.0 $ 2.3572 $ 2.9844 $ 3.235.0 "DPS (dividends per share)EPS (earnings per share) -310 one: S Member (relation): Montgomery Corporation 107 the last six years, even though their net income may have declined significantly Furthermore, the whole argument is meaningless, anyway, because the dividend is not really competing with the capital budget for funds we don't turn away profitable projects in favor of paying 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 financing for the investments from outside sources. In a way, we can have our cake and eat it too." She chuckled, pleased at the analogy. Don Jackson, however, was not to be intimidated so easily. "Yes, ma'am, what you say is true," he replied, and I would respond that competitors are not treating their stockholders fairly, either. Furthermore, you do seek outside financing 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 finance from outside sources than from inside due to the fees charged by the investment banker. Therefore, I believe you should exhaust our inside sources of financing before turning to the outside." Ms. Reynolds held her ground. "That's all very well, but it's still not necessary to cut the dividend in order to fund the capital budget. As a last resort, if the company'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, "Mr. 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 of changing to a residual policy, please raise your hand." Case 27 108 Required . Refer to Figure 1. Would you say that Montgomery's policy up to now has been to pay a constant dividend, with occasional increases as the company grows? Refer to Figure 2. What type of dividend policies would you say are being practiced by Montgomery's competitors in the retailing industry? Do you think that any firms are following a residual policy? Calculate the expected return to the common stockholders under the firm's present policy, given an expected dividend next year of $2.10 and a growth rate of 7.1 percent. Montgomery's stock currently sells for $35. (Use the dividend growth model): 2. Expected return (K) +g b. Assume that, if Don Jackson's proposal were adopted, next year's dividend would be zero but earnings growth would rise to 14 percent. What will be the expected return to the stockholders (assuming the other factors are held constant)? 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? 5. Do you go along with Clarence Autry's comment that it's what the stockholders want that counts, not their total rate of return? Why or why not? 6. Barbara Reynolds suggests that, if cash is needed for the capital budget, a stock dividend could be substituted for the cash dividend. Do you agree? How do you think the stockholders would react? Regardless of their reaction is the stock dividend an equivalent substitute for the cash dividend? 7. After all is said and done, do you think the firm's dividend policy matters? If so, what do you think Montgomery's policy should be