Rio Rubber Corporation follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm’s dividend per share?
Instructions:
- Type your name in the space provided above.
- This exam is worth up to a total of 250 points. It has two parts. Part 1 has six (6) concept questions worth a total of 90 points. Part 2 has five (5) problems worth a total of 160 points.
- Show your work to get credit on Part 2. You may type your work in this file or use Excel. Do not handwrite your answers. If you use Excel, make sure you submit the Excel file with this exam paper.
- Save your file(s) by including your name in the filename(s).
- No email submission will be considered; only work submitted via Blackboard will be graded. Late or missed submission will be assigned a score of zero.
Part 1 – Concept Questions (15 points each)
1. Rio Rubber Corporation follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm’s dividend per share?
A. The company increases the percentage of equity in its target capital structure.
B. The number of profitable potential projects increases.
C. Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed.
D. The firm’s net income increases.
E. Earnings are unchanged, but the firm issues new shares of common stock.
Answer is____D____. Why?
2. Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?
A. An increase in the company’s operating leverage.
B. An increase in the corporate tax rate.
C. The Federal Reserve tightens interest rates in an effort to fight inflation.
D. The company’s stock price hits a new high.
E. An increase in the personal tax rate.
Answer is_____A___. Why?
3. Which of the following actions should a firm take if it wants to reduce its cash conversion cycle?
A. Increase average inventory without increasing sales.
B. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales.
C. Sell common stock to retire long-term bonds.
D. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock.
E. Take steps to reduce the average collection period.
Answer is________. Why?
4. Define each of the following terms: (4.a) Stock split; (4.b) Stock dividend; and (4.c) Stock repurchase.
- Stock Splits Stock splits occur when a company perceives that its stock price may be too high. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range.Stock splits increase the number of shares outstanding and reduce the par or stated value per share of the company’s stock.
- Stock Dividends
One type of “dividend” that does not involve the distribution of value is known as a stock dividend. When a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to existing stockholders. The only thing that happens when the stock dividend is paid is that the number of shares each stockholder owns increases and their value goes down proportionately. The stockholder is left with exactly the same value as before.
- Stock Repurchases
With a stock repurchase, a company buys some of its shares from stockholders. How Stock Repurchases Differ from Dividends. Stock repurchases differ from dividends in four ways.
- First, they do not represent a pro-rata distribution of value to the stockholders because not all stockholders participate. Individual stockholders decide whether they want to participate in a share repurchase.
- Second, when a company repurchases its own shares, it removes them from circulation. This reduces the number of shares of stock that are held by investors, thereby removing a large number of shares from circulation. This can change the ownership of the firm.
- Third, stock repurchases are taxed differently than dividends. The total value of dividends is normally taxed. Conversely, when a stockholder sells shares back to the company, the stockholder is taxed only on the profit from the sale.
- Fourth, the way in which we account for dividends and stock repurchases on a company’s balance sheet is also different.
When the company pays a cash dividend, the cash account on the assets side of the balance sheet and the retained earnings account on the liabilities and stockholders’ equity side of the balance sheet are reduced. In contrast, when a company uses cash to repurchase stock, the cash account on the assets side of the balance sheet is reduced, while the treasury stock account on the liabilities and stockholders’ equity side of the balance sheet is increased.
5. Define each of the following terms: (5.a) Capital structure; (5.b) Business risk: and (5.c) Financial risk
a) The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. A firm’s capital structure can be a mixture of long-term debt, short-term debt, common equity and preferred equity. A company’s proportion of short- and long-term debt is considered when analyzing capital structure. When analysts refer to capital structure, they are most likely referring to a firm’s debt-to-equity (D/E) ratio, which provides insight into how risky a company is. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors. This risk, however, may be the primary source of the firm’s growth.
b) Business risk is the risk the firm if it uses no debt. Business risk arises from uncertainty in projected cash flows, which in turns means the uncertainty in operating profit and required capital investments. Uncertainty in future cash flows is caused by uncertainty about demand (unit sales), output prices, input costs, product and other types of liability, which in turns depends on business factors such as competition leverages, etc. is the possibility a company will have lower than anticipated profits or experience a loss rather than taking a profit. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, and the overall economic climate and government regulations. A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure it can meet its financial obligations at all times. Business risk impairs a company’s ability to provide its investors and stakeholders with adequate returns. The company is also exposed to financial risk, liquidity risk, systematic risk, exchange-rate risk and country-specific risk. This makes it increasingly important to minimize business risk. To calculate the risk, analysts use four simple ratios: contribution margin, operation leverage effect, financial leverage effect and total leverage effect. For more complex calculations, analysts can incorporate statistical methods. A company’s business risk is the risk of the firm’s assets when no debt is used. Business risk is the risk inherent in the company’s operations. As a result, there are many factors that can affect business risk: the more volatile these factors, the riskier the company.
c) Financial risk, is the additional risk placed on common stockholders as a result of the firm having debt (financial leverage). Financial risk depends on the amount of debt and preferred stock financing. However, takes into account a company’s leverage. If a company has a high amount of leverage, the financial risk to stockholders is high – meaning if a company cannot cover its debt and enters bankruptcy, the risk to stockholders not getting satisfied monetarily is high.
6. What is the primary goal of cash management?
The goal of cash management is to keep cash balances as low as possible while maintaining sufficient funds for transactions purposes and compensating balances. The goal of Cash management also helps to ensure that a company can manage its cash flow efficiently. In business receiving cash early helps the company in decreasing working capital requirements. Primary goal of cash management is to meet working capital requirements of the company. Cash management also helps the company to meet its debt obligations. As efficient cash management increases the profit of the company.
Part 2 – Quantitative Questions (Show your work to get credit)
7. Bike Inc.’s expected net income for next year is $1 million. The company’s target and current capital structure is 40% debt and 60% common equity. The optimal capital budget for next year is $1.2 million. If Bike uses the residual distribution model to determine next year’s distribution and makes all distributions in the form of dividends, what is the expected payout ratio? (15 points)
8. Palm Tree Corporation’s value of operations is estimated to be $650 million. Palm Tree has $100 million in debt (it has no preferred stock) and 10 million shares of common stock outstanding. Suppose Palm Tree has decided to distribute to its shareholders $65 million, which it is presently holding in T-bills.
8.a Assume that Palm Tree has not yet made the distribution. What is Palm Tree’s intrinsic value of equity? (10 points) What is its intrinsic stock price per share? (5 points)
8.b Now, suppose that Palm Tree has just made the $65 million distribution in the form of dividends. What is Palm Tree’s intrinsic stock price per share right after this dividend payment? (15 points)
8.c Suppose instead that Palm Tree has just made the $65 million distribution in the form of a stock repurchase. How many shares did Palm Tree repurchase? (5 points) What is its intrinsic stock price per share right after the repurchase? (10 points)
9. Seagull Inc. will produce 50,000 aquariums next year. Variable costs will equal 40% of dollar sales, while fixed costs total $100,000. At what price must each aquarium be sold for Seagull’s EBIT to be $90,000? (15 points)
10. The Tech Hardware Company is trying to estimate its optimal capital structure. Tech’s current capital structure consists of 20% debt and 80% equity; however, management believes the firm should use more debt. The risk-free rate is 1.3%, the market risk premium is 6%, and the firm’s tax rate is 35%. Currently, Tech’s cost of equity is 16%, which is determined on the basis of the CAPM.
10.a Determine Tech’s current beta. (10 points)
10.b What would be Tech’s unlevered beta? (10 points)
10.c If Tech were to change its capital structure from its current one so to have its assets and operations finance with 45% debt, determine its beta under this new capital structure. (10 points)
10.d Determine Tech’s new cost of equity under the new capital structure with 45% debt. (10 points)
10.e If the cost of debt were 6%, what would be Tech’s weighted average cost of capital under the new capital structure with 45% debt? (10 points)
11. Padre Inc. recently hired your consulting firm to improve the company’s performance. Padre has been highly profitable but has been experiencing cash shortages due to its high growth rate. As part of your analysis, you want to determine the firm’s cash conversion cycle and the firm’s cost of trade credit.
11.a Using the following information and a 365-day year, what is the firm’s current cash conversion cycle? (10 points) What would you recommend Padre to reduce its cash conversion cycle? (2.5 points)
| Inventory = | $75,000 |
| Sales = | $600,000 |
| Cost of goods sold = | $360,000 |
| Accounts receivable = | $160,000 |
| Accounts payable = | $25,000 |
11.b Currently, suppliers offer Padre credit terms of 2/10 net 30 days. What does this mean? (5 points) Padre is not taking the discount, but is paying in 25 days instead of waiting for the specified 30 days. Since Padre is neither taking the discount nor paying on the due date, what is Padre’s nominal annual percentage cost of its non-free trade credit? (5 points) What is the effective annual percentage cost of Padre’s non-free trade credit? (5 points)
11.c What would be the effective annual percentage cost of Padre’s non-free trade credit if Padre is not taking the discount but paying on Day 30? (5 points) How would you advise Padre about its non-free trade credit if it must use this trade credit? (2.5 points)
End of Midterm Exam
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