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(3) In the graph given here, we plot stock price versus dividend policy (payout) under the
dividend relevance theory and dividend irrelevance when investors prefer current
b. (1) It has long been recognized that the announcement of a dividend increase often results
in an increase in the stock price, whereas an announcement of a dividend cut typically
causes the stock price to fall. One could argue that this observation supports the
(2) Different groups, or clienteles, of stockholders prefer different dividend payout policies.
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(3) Investors expect financial managers to make decisions that help maximize the value of
the firm. If positive net present value capital budgeting projects are available for current
investment, the firm should invest in these projects. Thus, if investors want wealth
c. (1) Draw the WACC graph assuming no dividends are paid. The graph shows that the
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Given the optimal capital budget and the target capital structure, we must now
0.4($800,000) = $320,000 must be raised as debt if we are to maintain the optimal
capital structure:
If a residual exists, that is, if net income exceeds the amount of equity the company
needs, then it should pay the residual amount out in dividends. Because $600,000 of
However, if it were applied exactly, the residual policy would result in dividend
payments that fluctuated significantly from year to year as capital requirements and
1,000
Cost of Capital
(%)
CAPITAL RAISED
(THOUSANDS $)
800
IOS
0
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d. Three other dividend payment policies are (1) pay a stable, predictable dollar dividend, (2)
pay out a constant percentage of earnings, and (3) pay a low regular dividend plus an extra
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The stable, predictable dollar policy has two advantages. First, it provides stable,
predictable dividends that send investors positive signals about the stability of future
The low regular plus extras policy has advantages similar to the stable, predictable dollar
dividend policy, but, because the dollar amount is low, there is less risk that the firm will be
e. Under a dividend reinvestment plan (DRIP), shareholders have the option of automatically
reinvesting their dividends in shares of the firm’s common stock. In an open market
purchase plan, a trustee pools all the dividends to be reinvested and then buys shares on
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14-18 Computer-Related Problem
a. If the outstanding debt has to be refunded at the new higher interest rate, expected EPS
would decline under either financing plan. However, EPS would decline more if debt
financing were used. Therefore, debt financing has become relatively less attractive than
stock financing. The output generated by the model is:
INPUT DATA: KEY OUTPUT:
Financing alternatives: Using Debt financing:
Stock – Price per share $60 Expected EPS $5.60
Initial balance sheet data:
Current assets: $900.00
Net fixed assets: $450.00
Accounts payable: $172.50
MODEL-GENERATED DATA:
ANALYSIS IF DEBT FINANCING IS USED:
Probability 0.3 0.4 0.3
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Sales $2,250 $2,700 $3,150
ANALYSIS IF STOCK FINANCING IS USED:
Sales $2,250 $2,700 $3,150
EBIT 225 270 315
b. We can see from the output given below that the lower the interest rate, the better debt
financing looks. At a long-term interest rate of 5 percent, the expected EPS is significantly
LONG-TERM INTEREST RATE = 5 PERCENT
INPUT DATA: KEY OUTPUT:
Financing alternatives: Using Debt financing:
Stock – Price per share $60 Expected EPS $6.80
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Annual Sales Prob.
$2,250 0.30 Using Equity financing:
Amount financed $270
Tax rate 40%
Initial balance sheet data:
Current assets: $900.00
Net fixed assets: $450.00
MODEL-GENERATED DATA:
ANALYSIS IF DEBT FINANCING IS USED:
Probability 0.3 0.4 0.3
Sales $2,250 $2,700 $3,150
Expected EPS,
using debt: $6.80 Std. Dev. of EPS: $1.05
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EBIT 225 270 315
Interest on S-T debt (15) (15) (15)
Interest on L-T debt (15) (15) (15)
EBT $ 195 $ 240 $ 285
Taxes (78) (96) (114)
Net income $ 117 $ 144 $ 171
EPS $ 4.78 $ 5.88 $ 6.98
TIE 7.50 9.00 10.50
Expected EPS,
using stock: $ 5.88 Std. Dev. of EPS: $0.85
Expected TIE 9.00
LONG-TERM INTEREST RATE = 20 PERCENT
INPUT DATA: KEY OUTPUT:
Financing alternatives: Using Debt financing:
Stock – Price per share $60 Expected EPS $4.23
Standard Deviation 1.05
Initial balance sheet data:
Current assets: $900.00
Net fixed assets: $450.00
Accounts payable: $172.50
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MODEL-GENERATED DATA:
ANALYSIS IF DEBT FINANCING IS USED:
Probability 0.3 0.4 0.3
Sales $2,250 $2,700 $3,150
ANALYSIS IF STOCK FINANCING IS USED:
Sales $2,250 $2,700 $3,150
EBIT 225 270 315
c. This analysis shows that at the higher stock price, equity financing looks better. At very high
STOCK PRICE = $105:
INPUT DATA: KEY OUTPUT:
Financing alternatives: Using Debt financing:
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Debt ratio 75.46%
Annual Sales Prob.
Initial balance sheet data:
Current assets: $900.00
Net fixed assets: $450.00
Initial income statement data:
Sales $2,475.00
EBIT $247.50
MODEL-GENERATED DATA:
ANALYSIS IF DEBT FINANCING IS USED:
Probability 0.3 0.4 0.3
Sales $2,250 $2,700 $3,150
ANALYSIS IF STOCK FINANCING IS USED:
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Sales $2,250 $2,700 $3,150
EBIT 225 270 315
STOCK PRICE = $30:
INPUT DATA: KEY OUTPUT:
Financing alternatives: Using Debt financing:
Stock – Price per share $30 Expected EPS $5.60
Initial balance sheet data:
Current assets: $900.00
Net fixed assets: $450.00
Accounts payable: $172.50
14–32
Taxes $81.00
Net income $ 121.50
MODEL-GENERATED DATA:
ANALYSIS IF DEBT FINANCING IS USED:
Probability 0.3 0.4 0.3
Sales $2,250 $2,700 $3,150
ANALYSIS IF STOCK FINANCING IS USED:
Sales $2,250 $2,700 $3,150
EBIT 225 270 315
Interest on S-T debt (15) (15) (15)
d. These results indicate that debt financing is relatively better than equity financing if the
SALES LEVEL KNOWN WITH CERTAINTY
INPUT DATA: KEY OUTPUT:
Financing alternatives: Using Debt financing:
Stock – Price per share $60 Expected EPS $5.60
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Initial balance sheet data:
Current assets: $900.00
Net fixed assets: $450.00
Accounts payable: $172.50
Initial income statement data:
Sales $2,475.00
EBIT $247.50
MODEL-GENERATED DATA:
ANALYSIS IF DEBT FINANCING IS USED:
Probability 0.0 1.0 0.0
Sales $2,250 $2,700 $3,150
ANALYSIS IF STOCK FINANCING IS USED:
14–34
Sales $2,250 $2,700 $3,150
EBIT 225 270 315
SALES LEVEL UNCERTAIN
INPUT DATA: KEY OUTPUT:
Financing alternatives: Using Debt financing:
Stock – Price per share $60 Expected EPS $7.49
Standard Deviation 8.85
Initial balance sheet data:
Current assets: $900.00
Net fixed assets: $450.00
Accounts payable: $172.50
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MODEL-GENERATED DATA:
ANALYSIS IF DEBT FINANCING IS USED:
Probability 0.3 0.4 0.3
Sales $0 $2,700 $7,500
ANALYSIS IF STOCK FINANCING IS USED:
Sales $0 $2,700 $7,500
EBIT 0 270 750
14–19 a. With the proposed increase in the debt ratio, the marginal cost of capital before the break
INPUT DATA: KEY OUTPUTS:
Previous dividend: $3.00 Expected payout: 63.16%
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Debt ratio: 60.00%
Cost of new debt: 12.00% Optimal capital budget:
Net price new stock $51.25 Project IRR Cost
Investment:
Project Cost IRR Cum. Cost
MODEL-GENERATED DATA:
With proposed dividend:
Earnings 14,250,000
Marginal cost of capital up to break point:
After-Tax Weighted
Component Percent Cost Cost
After-Tax Weighted
Component Percent Cost Cost
Capital cost:
Range of financing Capital cost
Optimal capital budget:
Project IRR Cost
b. If rs rose to 16 percent, the MCC above the break would rise to 10.93 percent, which would
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INPUT DATA: KEY OUTPUTS:
Previous dividend: $3.00 Expected payout: 63.16%
c. No, the project selection would not be affected by a change in the dividend. The low return
INPUT DATA: KEY OUTPUTS:
Previous dividend: $3.00 Expected payout: 39.58%
Proposed dividend: $1.88 WACC before break: 10.72%
ETHICAL DILEMMA
A Bond Is a Bond … Is a Stock … Is a Bondock?
Ethical dilemma:
Wally is evaluating whether to use a new (to the United States) financial instrument to raise funds to
finance Ohio Rubber & Tire’s (ORT) expansion plans. The new instrument, which is called a bondock,
has some characteristics of traditional debt and some characteristics that are similar to common equity.
The cost of capital associated with bondocks is slightly higher than traditional debt, but significantly
lower than common equity. If ORT’s expansion plans are successful, both its bondholders and its
stockholders will receive handsome returns. However, if the expansion plans are not successful, then it
appears that stockholders can still benefit but at the expense of bondholders. ORT’s executives are
some of the company’s major stockholders, so it appears that they would be in favor of issuing
bondocks.
Discussion questions:
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• Is there an ethical problem? If so, what is it?
The question here is whether it is appropriate to use a new financial instrument called a bondock to
raise funds needed for expansion. Because the cost of capital associated with a bondock is slightly
• Is it appropriate for ORT to use bondocks to raise funds that are needed for expansion?
Is there an ethical dilemma here? Maybe not. Remember that investors take risks when purchasing
• What would you do if you were Wally?
It seems that the best solution is for Wally to try to get more information about the new financial
References:
The following articles might be assigned for background material:
Emily Thornton, “Gluttons at the Gate,” BusinessWeek, October 30, 2006, pp. 58-66.
David Henry, “Cross–Dressing Securities,” BusinessWeek, March 13, 2006, pp. 58-59.