Principles of Finance 6e Chapter 14
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CHAPTER 14
ANSWERS
14-1 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges also will
14-2 The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s
14-3 Expected EPS generally is measured as EPS for the coming years, and we typically do not
14-4 EBIT depends on sales and operating costs that generally are not affected by the firm’s use of
14-7 With increased competition after the breakup of AT&T, the new AT&T and the seven Bell
operating companies’ business risk increased. With this component of total company risk
14-8 Several possibilities exist for the firm, but trying to match the length of the project with the
maturity of the financing plan seems to be the best approach. The firm might want to finance the
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14-9 The way this question is worded, the decision would have to be made on an individual basis. In
our opinion, investors who intend to invest in companies that maintain a relatively high payout
probably are seeking income and would prefer to receive a stable, or predictably increasing,
14–10 a. From the stockholders’ point of view, if the capital gains tax rate stays constant, an increase
in the personal income tax rate would make it more desirable for a firm to retain and
reinvest earnings. Consequently, an increase in personal tax rates should lower the
aggregate payout ratio.
14–11 While it is true that the cost of outside equity is higher than that of retained earnings, it is not
14–12 Logic suggests that stockholders like stable dividends—many of them depend on dividend
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14–13 a. The residual dividend policy is based on the premise that, because new common stock is
more costly than retained earnings, a firm should use all the retained earnings it can to
14-14 The difference is largely one of accounting. In the case of a split, the firm simply increases the
number of shares and simultaneously reduces the par or stated value per share. In the case of
14–15 If outside investors have the same information as the executives who run the company, then
14–16 If investors do not have the same information as the executives who run the company and the
SOLUTIONS
14-1 a. LL: D/TA = 30%; Debt = 0.3($20 million) = $6 million
EBIT $4,000,000
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b. LL: D/TA = 60%; debt = 0.6($20 million) = $12 million
EBIT $4,000,000
14-2 Equity financing = 0.5($120,000) = $60,000
14-3 Retention ratio = $400,000/$1,000,000 = 0.40 = 40.0%
14-4 Dividend payout ratio = $6,000,000/$15,000,000 = 0.4 = 40.0%
14-5 a. Price = $3 x 3.0 = $9
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14-6 DPS after split = $0.75.
14-7 Retained earnings = Net income (1 – Payout ratio) = $5,000,000(0.55) = $2,750,000
External equity needed:
14-8 Equity financing = $12,000,000(0.60) = $7,200,000
14-9 Break point if all earnings retained = NI/Equity ratio = $7,287,500/0.5 = $14,575,000
10
14
18
%
15
5
10
20
$
A
B
C
WACC2
WACC1
Optimal Capital Budget
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14-10 No leverage: D = 0 (debt); E = $14,000,000 (equity)
Net Income = ROE =
State Pr EBIT (EBIT – rdD)(1 – T) NI/S Pr x (ROE) Pr(ROE –
ROE
)2
1 0.2 $4,200,000 $2,520,000 0.18 0.036 0.00113
Net Income = ROE =
State Pr EBIT (EBIT – rdD)(1 – T) NI/S Pr x (ROE) Pr(ROE –
ROE
)2
1 0.2 $4,200,000 $2,444,400 0.194 0.039 0.00138
Net Income = ROE =
State Pr EBIT (EBIT – rdD)(1 – T) NI/S Pr x (ROE) Pr(ROE –
ROE
)2
1 0.2 $4,200,000 $2,058,000 0.294 0.059 0.00450
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Net Income = ROE =
State Pr EBIT (EBIT – rdD)(1 – T) NI/S Pr x (ROE) Pr(ROE –
ROE
)2
1 0.2 $4,200,000 $1,814,400 0.324 0.065 0.00699
14–11 a. Expected EPS for Firm C:
b. According to the standard deviations of EPS, Firm B is the least risky, while Firm C is the
riskiest. However, this analysis does not take account of portfolio effects—if Firm C’s
earnings go up when most other companies’ decline (that is, its beta is low), its apparent
riskiness would be reduced when combined with other assets. Also, standard deviation is
related to size, or scale, and to correct for scale we could calculate a coefficient of variation
(σ/mean):
E(EPS) σ CV = σ/E(EPS)
A $5.10 $3.61 0.71
14–12 a. Without new investment
Sales $12,960,000 = $288 × 45,000 units
1. EPSOld = $489,600/240,000 = $2.04.
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With new investment Debt Stock
Sales $12,960,000 $12,960,000
b.
Shares
)T1](IF)VP(Q[
EPS −−−−
=
33.181$
000,45
000,160,8$
V==
000,240
)4.01](000,104,1$000,800,1$Q)33.181$00.288[($
EPSDebt
−−−−
=
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c. VOld = $10,200,000/45,000 = $226.67
units 475,20Q
=
d. At the expected sales level, 45,000 units, we have these EPS values:
EPSOld Setup = $2.04.
000,240
60.0$
000,480
)4.01](000,384$000,800,1$000,25)33.181$00.288[($
EPSStock =
−−−−
=
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14–13 Use of debt ($ millions):
Probability 0.3 0.4 0.3
Sales $2,250.0 $2,700.0 $3,150.0
Use of stock (Millions of dollars):
Probability 0.3 0.4 0.3
Sales $2,250.0 $2,700.0 $3,150.0
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14–14 a. 1. 2016 Dividends = (1.10)(2015 Dividends) = (1.10)($3,600,000) = $3,960,000
3. Equity financing = $8,400,000(0.60) = $5,040,000.
4. The regular dividends would be 10 percent above the 2015 dividends:
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b. Policy 4, based on the regular dividend with an extra, seems most logical. Implemented
14–15 a. Payout = ($3.00 x 3,000,000)/($14,250,000) = 63.16%.
With a $3.00 dividend:
million 55.9$
55.0
million 25.5$
BPRE ==
Marginal cost up to $9.55 million:
After-Tax Weighted
Component Percent Cost Cost
Debt 0.45 0.0660 0.0297
Marginal cost above $9.55 million:
After-Tax Weighted
Component Percent Cost Cost
Debt 0.45 0.0660 0.0297
$51.25
With no dividend:
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million 25.14$
b. Ybor’s capital budget should be $15 million, because only the growth project’s return
exceeds the marginal cost of capital.
c. Ybor’s management should expect that its intended policy of moving into new growth fields
will open up better investment opportunities, which presumably will require more funds than
Assuming the $3.00 dividend, financing should be as follows:
Capital budget: $15,000,000
New debt = 0.45($15,000,000): (6,750,000)
d. Generally, new areas of business involve greater-than-average risk as well as greater-than-
average expected returns. The new growth aspects of Ybor City Tobacco might cause
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(2) Conclusions from the analysis:
(i) Firm L has the higher expected ROE:
(ii) Firm L has a wider range of ROEs, and a higher standard deviation of ROE,
indicating that its higher expected return is accompanied by higher risk. To be
precise:
(iv) Leverage will boost expected ROE if the expected unlevered ROA exceeds the
d. (1) The optimal capital structure is the capital structure at which the tax-related benefits of
(2) Here is the sequence of events:
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(iii) For simplicity, we assume that the firm could repurchase stock at its current price,
$20, which also happens to be its book value per share. In actuality, investors
(iv) CDSS would purchase stock, then issue debt and use the proceeds to pay for the
(3) The analysis for the debt levels being considered (in thousands of dollars and shares) is
shown below:
At Debt = $0:
=
nterestI
EBIT
= TIE
At Debt = $250,000:
Shares repurchased = $250,000/$20 = 12,500.
20 =
$25
$500
= TIE
At Debt = $500,000:
Shares repurchased = $500,000/$20 = 25,000.
4-17
5.1 =
$97.5
$500
= TIE
At Debt = $1,000,000:
Shares repurchased = $1,000,000/$20 = 50,000.
3.1 =
$160
$500
= TIE
(4) We can calculate the price of a constant growth stock as DPS divided by rs minus g,
where g is the expected growth rate in dividends:
Because in this case all earnings are paid out to the stockholders, DPS = EPS. Further,
because no earnings are plowed back, the firm’s EBIT is not expected to grow, so g =
0. Here are the results:
Debt Level DPS rs Stock Price
$ 0 $3.00 15.0% $20.00
14–18
(7) Currently, Debt/Total assets = 0%, so total assets = initial equity = $20 x 100,000
shares = $2,000,000.
e. If the firm had higher business risk, then, at any debt level, its probability of financial
f. Because it is difficult to quantify the capital structure decision, managers consider the
following judgmental factors when making capital structure decisions:
(1) The average debt ratio for firms in their industry.
g. The asymmetric information concept is based on the premise that management’s choice of
financing gives signals to investors. Firms with good investment opportunities will not want
h. When it uses a stock dividend, a firm issues new shares in lieu of paying a cash dividend.
For example, in a 5 percent stock dividend, the holder of 100 shares would receive an
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4-19
Both stock dividends and stock splits increase the number of shares outstanding and, in
effect, cut the pie into more, but smaller, pieces. If the dividend or split does not occur at the
same time as some other event that would alter perceptions about future cash flows, such
as an announcement of higher earnings, then one would expect the price of the stock to
adjust such that each investor’s wealth remains unchanged. For example, a 2–for-1 split of a
stock selling for $50 would result in the stock price being cut in half, to $25.
It is hard to come up with a convincing rationale for small stock dividends, like 5 percent or
10 percent. No economic value is being created or distributed, yet stockholders have to
bear the administrative costs of the distribution. Further, it is inconvenient to own an odd
number of shares as can result after a small stock dividend. Thus, most companies today
avoid small stock dividends.
On the other hand, there is a good reason for stock splits or large stock dividends.
Specifically, there is a widespread belief that an optimal price range exists for stocks. The
argument goes as follows: if a stock sells for about $20-$80, then it can be purchased in
14-17 Integrative Problem
a. (1) Dividend policy is defined as the firm’s policy with regard to paying out earnings as
(2) Dividend irrelevance refers to the theory that investors are indifferent between
dividends and capital gains, making dividend policy irrelevant with regard to its effect
on the value of the firm. On the other hand, according to the dividend relevance