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A 14problem

E
27.12.2007 09:27

I 10.02.2003

Chapter 14. Solution to end-of-chapter spreadsheet problem

Problem 14-10 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 will require $10 million to fund all of its profitable (i.e., 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? Answer: Input Data DPS Target equity ratio Target debt ratio Shares outstanding Net Income Total capital budget

$3,00 60% 40% 1.000.000 $8.000.000 $10.000.000 Total capital budget x $10.000.000 x $6.000.000 Target equity ratio 60%

Required retained earnings = Required retained earnings = Required retained earnings =

b. If Buena Terra follows the residual dividend model, what will the company's dividend per share and payout ratio be for the upcoming year? Dividend per share = Dividend per share = Dividend per share = Dividend payout ratio Dividend payout ratio Dividend payout ratio (Net Income $8.000.000 $2,00 = = = Required RE) / Shares outstanding $6.000.000 / 1.000.000 So, following the residual policy would require a dividend cut. Dividend paid $2.000.000 25% / / Net Income $8.000.000

c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available to support the capital budget? Desired DPS = $3,00 Net Income $8.000.000 $5.000.000 DPS $3,00 x x # of shares 1.000.000

Retained earnings for cap. budget = Retained earnings for cap. budget = Retained earnings for cap. budget =

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A B C D E F G 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?

NO We see in that the required retained earnings to maintain the capital structure is $6 million, while the retained earnings left for the capital budget if the $3 dividend is maintained is only $5 million. This means the firm would have to issue new common stock. e. Suppose that Buena Terra's board is firmly opposed to cutting the dividend, that is, insists on maintaining the $3.00 dividend. Also, assume that the company is committed to funding all profitable projects and is willing to issue more debt (along with the available retained earnings) to help finance the capital budget. Assume that the resulting change in capital structure has a minimal impact on the company's composite cost of capital, so that the capital budget remains at $10 million. What % of this year's capital budget would have to be financed with debt? DPS Total capital budget Dividends paid = Dividends paid = Dividends paid = RE Available RE Available RE Available = = = $3,00 $10.000.000 DPS $3,00 $3.000.000 Net Income $8.000.000 $5.000.000 x x # of shares 1.000.000

Dividends paid $3.000.000

Portion of cap. budget from equity = Portion of cap. budget from equity = Portion of cap. budget from equity = Portion of cap. budget from debt Portion of cap. budget from debt = =

RE to be used $5.000.000 50% 100% 100% 50%

/ /

Total capital budget $10.000.000

Portion of cap. budget from equity 50%

f. Suppose once again that Buena Terra's management wants to maintain the $3.00 DPS. It also wants to maintain its target capital structure (60 percent equity, 40 percent debt) and to finance a $10 million capital budget. What is the minimum dollar amount of new common stock that must be issued to meet these objectives? From part A, we see the required retained earnings is $6 million, but we see in part E that there would only be $ 5million available in retained earnings. Therefore, the company must issue $1 million of stock. g. Now suppose Buena Terra's management wants to maintain the $3.00 DPS and its target capital structure, but it does not want to issue new common stock. Management is willing to cut the capital budget to meet these objectives. Assuming the projects are divisible, what will the company's capital budget be for the next year? Total capital budget = Available RE = $5.000.000 Total capital budget = $8.333.333 / / Target Equity ratio 60%