1. Suppose you have 100 common shares of Tillman Industries. The EPS is $4.00, the DPS is $2.

00, and the

3. Emergency Medical’s stock trades at $145 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 company’s
stock price following the stock split?

4. In 2011, Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. Note that
2011 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However,
in 2012, 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 2012 level of earnings
growth—the high 2012 earnings level is attributable to an exceptionally profitable new product line introduced
that year—and the company will return to its previous 10% growth rate. Keenan’s target capital structure is 40%
debt and 60% equity.
a) Calculate Keenan’s total dividends for 2012 assuming that it follows each of the following policies:
i) Its 2012 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
ii) It continues the 2011 dividend payout ratio.
iii) It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt and
60% with common equity).
iv) 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) Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2012 and to have the dividend
grow at 10% after 2012. The stock’s total market value is $180 million. What is the company’s cost of
equity?
c) What is Keenan’s long-run average return on equity?

5. American Development Corporation (ADC) expects to earn $4.4 million in 2009, and 50% of this amount
(or $2.2 million) has been allocated for distribution to common shareholders. There are 1.1 million shares
outstanding, and the market price is $20 a share. ADC believes that it can use the $2.2 million to repurchase
100,000 of its shares through a tender offer at $22 a share or pay a cash dividend of $2 a share. What is the
effect of the repurchase on the EPS and market price per share of the remaining stock?

6. Gamma Medical’s 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
company’s stock price following the stock split?

7. Bowles Sporting Inc. is prepared to report the following income statement (shown in thousands of dollars)
for the year 2009.

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 in
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 company’s
stock?
c) The company reported net income of $1.5 million in 2008. Assume that the number of shares outstanding
has remained constant. What was the company’s 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 company’s
dividend payout ratio in 2009?

8. Beta Industries has net income of $2,000,000, and it has 1,000,000 shares of common stock outstanding.
The company’s 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 company’s P/E ratio. What will be Beta’s stock price following the stock repurchase?

9. 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
company’s target capital structure, the firm has $10 million in assets, of which 40% is funded by debt. Assume
that the firm’s 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?
b) What is the stock’s required return?
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 firm’s stock price or ROE. Therefore,
what must be the firm’s new expected long-run growth rate and required return?
10. Altamonte Telecommunications has a target capital structure that consists of 45% debt and 55% equity. The
company anticipates that its capital budget for the upcoming year will be $1,000,000. If Altamonte reports net
income of $1,200,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio?

11. 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 2018, 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 6% 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 (rs = 14%) would amount to only $800,000 for 2019 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 2019; 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 2019. Given the dramatically changed circumstances, CMC’s
management is reviewing the firm’s dividend policy.
a) Assuming that the acceptable 2019 investment projects would be financed entirely by earnings retained
during the year and assuming that CMC uses the residual dividend model, calculate DPS in 2019.
b) What payout ratio does your answer to Part (a) imply for 2019?
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.
d) What would happen to the stock price if the old 20% payout was continued? Assume that if this payout is
maintained, the average rate of return on the retained earnings will fall to 7.5% and the new growth rate will
be as follows:

g = (1 – Payout Ratio)(ROE)
= (1 – 0.2)(7.5%) = 6.0%

12. 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 net
 income of $2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout
ratio?

13. Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating
system. To meet this demand, management Northern Pacific Heating and Cooling Inc. has a 6-month
backlog of orders for its patented solar heating system. To meet this demand, management 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 year’s 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.

14. After a 5-for-1 stock split, the Strasburg Company paid a dividend of $0.75 per new share, which
represents a 9 percent increase over last year’s pre-split dividend. What was last year’s dividend
per share?
15. The 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
company’s optimal capital structure calls for 50 percent debt and 50 percent common equity.
Welch expects to have net income of $7,287,500. If Welch establishes its dividends from the
residual model, what will be its payout ratio?
16. Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a
$3.00 dividend per share (DPS) for the past several years, and its shareholders expect the
dividend to remain constant for the next several years. The company’s target capital structure is
60 percent equity and 40 percent debt; it has 1,000,000 shares of common equity outstanding;
and its net income is $8 million. The company forecasts that it would require $10 million to fund
all of its profitable (that is, positive NPV) projects for the upcoming year. a. If Buena Terra
follows the residual dividend model, how much retained earnings will it need to fund its capital
budget? b. If Buena Terra follows the residual dividend model, what will be the company’s
dividend per share and payout ratio for the upcoming year? c. If Buena Terra maintains its
current $3.00 DPS for next year, how much retained earnings will be available for the firm’s
capital budget? d. Can the company maintain its current capital structure, maintain the $3.00
DPS, and maintain a $10 million capital budget without having to raise new common stock? e.
Suppose that Buena Terra’s management is firmly opposed to cutting the dividend; that is, it
wishes to maintain the $3.00 dividend for the next year. Also, assume that the company was
committed to funding all profitable projects and was willing to issue more debt (along with the
available retained earnings) to help finance the company’s capital budget. Assume that the
resulting change in capital structure has a minimal effect on the company’s composite cost of
capital, so that the capital budget remains at $10 million. What portion of this year’s capital
budget would have to be financed with debt? f. Suppose once again that Buena Terra’s
management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its
target capital structure (60 percent equity and 40 percent debt) and maintain its $10 million
capital budget. What is the minimum dollar amount of new common stock that the company
would have to issue in order to meet each of its objectives? g. Now consider the case where
Buena Terra’s management wants to maintain the $3.00 DPS and its target capital structure, but
it wants to avoid issuing new common stock. The company is willing to cut its capital budget in
order to meet its other objectives. Assuming that the company’s projects are divisible, what will
be the company’s capital budget for the next year? h. What actions can a firm that follows the
residual dividend policy take when its forecasted retained earnings are less than the retained
earnings required to fund its capital budget?