Establishing A Dividend Policy

How do firms actually determine the level of dividends they will pay at a particular time As we have seen, there are good reasons for firms to pay high dividends, and there are good reasons to pay low dividends. We know some things about how dividends are paid in practice. Firms don't like to cut dividends. Consider the case of The Stanley Works, maker of Stanley tools and other building products. As of 2001, Stanley had paid dividends for 124 years, longer than any other industrial company...

Residual Dividend Approach

Earlier, we noted that firms with higher dividend payouts will have to sell stock more often. As we have seen, such sales are not very common, and they can be very expensive. Consistent with this, we will assume that the firm wishes to minimize the need to sell new equity. We will also assume that the firm wishes to maintain its current capital structure. Ross et al. Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition VI. Cost of Capital and Long-Term Financial Policy CHAPTER 18...

Getting Started Pro Forma Financial Statements

Pro forma financial statements are a convenient and easily understood means of summarizing much of the relevant information for a project. To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We will also need to know the total investment required, including any investment in net working capital. To illustrate, suppose we think we can sell 50,000 cans of shark attractant per year at a...

Info

PART SIX Cost of Capital and Long-Term Financial Policy Suppose the only owners of stock are corporations. Recall that corporations get at least a 70 percent exemption from taxation on the dividend income they receive, but they do not get such an exemption on capital gains. If the corporation's income and capital gains tax rates are both 35 percent, what does this model predict the ex-dividend share price will be What does this problem tell you about real-world tax considerations and the...

Choosing a Venture Capitalist

Some start-up companies, particularly those headed by experienced, previously successful entrepreneurs, will be in such demand that they will have the luxury of looking beyond the money in choosing a venture capitalist. There are some key considerations in such a case, some of which can be summarized as follows 1. Financial strength is important. The venture capitalist needs to have the resources and financial reserves for additional financing stages should they become necessary. This doesn't...

Electronic Data Interchange The End of Float

Electronic data interchange (EDI) is a general term that refers to the growing practice of direct, electronic information exchange between all types of businesses. One important use of EDI, often called financial EDI, or FEDI, is to electronically transfer financial information and funds between parties, thereby eliminating paper invoices, paper checks, mailing, and handling. For example, it is now possible to arrange to have your checking account directly debited each month to pay many types...

The Cost of Preferred Stock

Determining the cost of preferred stock is quite straightforward. As we discussed in Chapters 6 and 8, preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is essentially a perpetuity. The cost of preferred stock, RP, is thus where D is the fixed dividend and P0 is the current price per share of the preferred stock. Notice that the cost of preferred stock is simply equal to the dividend yield on the preferred stock. Alternatively, because preferred...

Value of Stock Splits and Stock Dividends

The laws of logic tell us that stock splits and stock dividends can (1) leave the value of the firm unaffected, (2) increase its value, or (3) decrease its value. Unfortunately, the issues are complex enough that one cannot easily determine which of the three relationships holds. The Benchmark Case A strong case can be made that stock dividends and splits do not change either the wealth of any shareholder or the wealth of the firm as a whole. In our preceding example, the equity had a total...

Chapter Review and Self Test Problems

18.1 Residual Dividend Policy The Readata Corporation practices a strict residual dividend policy and maintains a capital structure of 60 percent debt, 40 percent equity. Earnings for the year are 5,000. What is the maximum amount of capital spending possible without selling new equity Suppose that planned investment outlays for the coming year are 12,000. Will Readata be paying a dividend If so, how much Ross et al. Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition VI. Cost...

Homemade Dividends

There is an alternative and perhaps more intuitively appealing explanation of why dividend policy doesn't matter in our example. Suppose individual investor X prefers dividends per share of 100 at both Dates 1 and 2. Would she be disappointed if informed that the firm's management was adopting the alternative dividend policy (dividends of 110 and 89 on the two dates, respectively) Not necessarily, because she could easily reinvest the 10 of unneeded funds received on Date 1 by buying some more...

Questions and Problems

Dividends and Taxes Caputo, Inc., has declared a 5.00 per share dividend. Suppose capital gains are not taxed, but dividends are taxed at 34 percent. New IRS regulations require that taxes be withheld at the time the dividend is paid. Caputo sells for 80 per share, and the stock is about to go ex dividend. What do you think the ex-dividend price will be 2. Stock Dividends The owners' equity accounts for Octagon International are shown here Ross et al. Fundamentals of Corporate Finance, Sixth...

The Metallica Heavy Metal Mining Mhmm Corporation Wants To Diversify Its Operations. Some Recent Financial Information

Dilution The Metallica Heavy Metal Mining MHMM Corporation wants to diversify its operations. Some recent financial information for the company is shown here MHMM is considering an investment that has the same PE ratio as the firm. The cost of the investment is 1,100,000, and it will be financed with a new equity issue. The return on the investment will equal MHMM's current ROE. What will happen to the book value per share, the market value per share, and the EPS What is the NPV of this...

Concepts Review and Critical Thinking Questions

WACC On the most basic level, if a firm's WACC is 12 percent, what does this mean 2. Book Values versus Market Values In calculating the WACC, if you had to use book values for either debt or equity, which would you choose Why 3. Project Risk If you can borrow all the money you need for a project at 6 percent, doesn't it follow that 6 percent is your cost of capital for the project 4. WACC and Taxes Why do we use an aftertax figure for cost of debt but not for cost of equity 5. DCF Cost of...

Types of Underwriting

Two basic types of underwriting are involved in a cash offer firm commitment and best efforts. Firm Commitment Underwriting In firm commitment underwriting, the issuer sells the entire issue to the underwriters, who then attempt to resell it. This is the most prevalent type of underwriting in the United States. This is really just a purchase-resale arrangement, and the underwriter's fee is the spread. For a new issue of seasoned equity, the underwriters can look at the market price to determine...

Market Value Measures

Our final group of measures is based, in part, on information not necessarily contained in financial statements the market price per share of the stock. Obviously, these measures can only be calculated directly for publicly traded companies. We assume that Prufrock has 33 million shares outstanding and the stock sold for 88 per share at the end of the year. If we recall that Prufrock's net income was 363 million, then we can calculate that its earnings per share were Price-Earnings Ratio The...

T-bills Rates At Their Highest Over The Period Why Do You Think They Were So High

Risk Premiums Refer to Table 12.1 in the text and look at the period from Basic 1970 through 1975. continued a. Calculate the average returns for large-company stocks and T-bills over this time period. b. Calculate the standard deviation of the returns for large-company stocks and T-bills over this time period. c. Calculate the observed risk premium in each year for the large-company stocks versus the T-bills. What was the average risk premium over this period What was the standard deviation...

Some Common Misconceptions about the EMH

No other idea in finance has attracted as much attention as that of efficient markets, and not all of the attention has been flattering. Rather than rehash the arguments here, we will be content to observe that some markets are more efficient than others. For example, financial markets on the whole are probably much more efficient than real asset markets. Having said this, however, we can also say that much of the criticism of the EMH is misguided because it is based on a misunderstanding of...

Long Term Debt The Basics

Ultimately, all long-term debt securities are promises made by the issuing firm to pay principal when due and to make timely interest payments on the unpaid balance. Beyond this, there are a number of features that distinguish these securities from one another. We discuss some of these features next. The maturity of a long-term debt instrument is the length of time the debt remains outstanding with some unpaid balance. Debt securities can be short-term with maturities of one year or less or...

Standard

Bond Ratings Look up Coca-Cola KO , Gateway GTW , Callaway Golf ELY , and Navistar International NAV . For each company, follow the Financial Highlights link and find the bond rating. Which companies have an invest- SPOOR'S ment grade rating Which companies are rated below investment grade Are any - unrated When you find the credit rating for one of the companies, click on the S amp P Issuer Credit Rating link. What are the three considerations listed that Standard amp Poor's uses to issue a...

The Tax Shield Approach

The third variation on our basic definition of OCF is the tax shield approach. This approach will be very useful for some problems we consider in the next section. The tax shield definition of OCF is OCF Sales - Costs X 1 - T Depreciation X T 10.3 where T is again the corporate tax rate. Assuming that T 34 , the OCF works out to be OCF 1,500 - 700 X .66 600 X .34 528 204 732 This approach views OCF as having two components. The first part is what the project's cash flow would be if there were...

Nwc Investment And An Annual Ocf The Fixed Asset Is Fully Depreciated Required Return Is 18 Percent The Project S

Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition 10. Making Capital Investment Decisions 17. Calculating EAC A five-year project has an initial fixed asset investment of 225,000, an initial NWC investment of 20,000, and an annual OCF of - 25,000. The fixed asset is fully depreciated over the life of the project and has no salvage value. If the required return is 15 percent, what is this project's equivalent annual cost, or EAC 18. Calculating EAC You are...

Financial Planning Model The Ingredients

Most financial planning models require the user to specify some assumptions about the future. Based on those assumptions, the model generates predicted values for a large number of other variables. Models can vary quite a bit in terms of their complexity, but almost all will have the elements that we discuss next. Sales Forecast Almost all financial plans require an externally supplied sales forecast. In our models that follow, for example, the sales forecast will be the driver, meaning that...

Suppose A Company Has Both A Preferred Stock Issue And A

Dividend Growth Model Under what two assumptions can we use the dividend growth model presented in the chapter to determine the value of a share of stock Comment on the reasonableness of these assumptions. 5. Common versus Preferred Stock Suppose a company has a preferred stock issue and a common stock issue. Both have just paid a 2 dividend. Which do you think will have a higher price, a share of the preferred or a share of the common 6. Dividend Growth Model Based on the dividend growth...

Organization of the NYSE

The New York Stock Exchange, or NYSE, popularly known as the Big Board, recently celebrated its bicentennial. It has occupied its current location on Wall Street since the turn of the twentieth century. Measured in terms of dollar volume of activity and the total value of shares listed, it is the largest stock market in the world. NYSE members who execute customer orders to buy and sell stock transmitted to the exchange floor. A NYSE member acting as a dealer in a small number of securities on...

C D

Debt rated Aaa and AAA has the highest rating. Capacity to pay interest and principal is extremely strong. Debt rated Aa and AA has a very strong capacity to pay interest and repay principal. Together with the highest rating, this group comprises the high-grade bond class. Debt rated A has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than debt in high-rated categories....

With The First Payment Occuring Today Your Child S 18th Birthday

After the child's sixth birthday, no more payments are made. When the child reaches age 65, he or she receives 175,000. If the relevant interest rate is 10 percent for the first six years and 6 percent for all subsequent years, is the policy worth buying 69. Calculating a Balloon Payment You have just arranged for a 300,000 mortgage to finance the purchase of a large tract of land. The mortgage has a 9 percent APR, and it calls for monthly payments over the next 15 years. However, the loan has...

Calculating Ear With Points

Calculating Present Values A 5-year annuity of ten 8,000 semiannual payments will begin 9 years from now, with the first payment coming 9.5 years from now. If the discount rate is 14 percent compounded monthly, what is the value of this annuity five years from now What is the value three years from now What is the current value of the annuity 56. Calculating Annuities Due As discussed in the text, an ordinary annuity assumes equal payments at the end of each period over the life of the...

Financial Policy and Growth

Based on our discussion just preceding, we see that there is a direct link between growth and external financing. In this section, we discuss two growth rates that are particularly useful in long-range planning. The Internal Growth Rate The first growth rate of interest is the maximum growth rate that can be achieved with no external financing of any kind. We will call this the internal growth rate because this is the rate the firm can maintain with internal financing only. In Figure 4.1, this...

Example

Asset Turnover Ratios Moving away from specific accounts like inventory or receivables, we can consider several big picture ratios. For example, NWC turnover is This ratio measures how much work we get out of our working capital. Once again, assuming we aren't missing out on sales, a high value is preferred why . Similarly, fixed asset turnover is PricewaterhouseCoopers has a useful utility for extracting EDGAR data. Try it at edgarscan. pwcglobal.com. With this ratio, it probably makes more...

Corporate Finance And The Financial Manager

In this section, we discuss where the financial manager fits in the corporation. We start by defining corporate finance and the financial manager's job. Imagine that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another 1. What long-term investments should you take on That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will 2. Where will you get the...

Financial Markets And The Corporation

We've seen that the primary advantages of the corporate form of organization are that ownership can be transferred more quickly and easily than with other forms and that money can be raised more readily. Both of these advantages are significantly enhanced by the existence of financial markets, and financial markets play an extremely important role in corporate finance. The interplay between the corporation and the financial markets is illustrated in Figure 1.2. The arrows in Figure 1.2 trace...

You Ve Just Joined The Investment Banking Firm Of Dewey Cheatum And Howe.

Simple Interest versus Compound Interest First Simple Bank pays 6 percent simple interest on its investment accounts. If First Complex Bank pays interest on its accounts compounded annually, what rate should the bank set if it wants to match First Simple Bank over an investment horizon of 10 years Calculating EAR You are looking at an investment that has an effective annual rate of 14 percent. What is the effective semiannual return The effective quarterly return The effective monthly return...

Aspirant Group Analysis

Capital intensity ratio Total asset turnover Equity multiplier Long-term debt ratio i. Return on assets j. Return on equity Standardized Financial Statements What types of information do common-size financial statements reveal about the firm What is the best use for these common-size statements What purpose do common-base year statements have When would you use them Peer Group Analysis Explain what peer group analysis means. As a financial manager, how could you use the results of peer group...

Short Term Solvency or Liquidity Measures

As the name suggests, short-term solvency ratios as a group are intended to provide information about a firm's liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm's ability to pay its bills over the short run without undue stress. Consequently, these ratios focus on current assets and current liabilities. For obvious reasons, liquidity ratios are particularly interesting to short-term creditors. Because financial managers are constantly working...

Roe

Sales Assets Total equity If we rearrange things a bit, ROE is Net income Sales ROE - -X --X Return on assets Profit margin X Total asset turnover X Equity multiplier What we have now done is to partition ROA into its two component parts, profit margin and total asset turnover. The last expression of the preceding equation is called the Du Pont identity, after the Du Pont Corporation, which popularized its use. We can check this relationship for Prufrock by noting that the profit margin was...

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PART TWO Financial Statements and Long-Term Financial Planning 7. Product Pricing The firm actually priced its product to be about 20 percent less than that of competitors, even though the Grandmother calendar was more detailed. In retrospect, was this a wise choice 8. Corporate Borrowing If the firm was so successful at selling, why wouldn't a bank or some other lender step in and provide it with the cash it needed to continue 9. Cash Flow Which is the biggest culprit here too many orders, too...

Andretti Driving School Dec 31 2002 Balance

PART ONE Overview of Corporate Finance Calculating OCF Gonas, Inc., has sales of 9,750, costs of 5,740, depreciation expense of 1,000, and interest expense of 240. If the tax rate is 35 percent, what is the operating cash flow, or OCF Calculating Net Capital Spending Andretti Driving School's December 31, 2001, balance sheet showed net fixed assets of 3.1 million, and the December 31, 2002, balance sheet showed net fixed assets of 3.5 million. The company's 2002 income statement showed a...

Pens Inc Has Projected A Sales Volume

Key Equations Called out in the text, key equations are identified by a blue equation number. The list in Appendix B shows the key equations by chapter, providing students with a convenient reference. For examples, see Chapter 5, page 131 Chapter 10, page 332. Highlighted Concepts Throughout the text, important ideas are pulled out and presented in a highlighted box signaling to students that this material is particularly relevant and critical for their understanding. See Chapter 4, page 114...

Some Caveats Regarding Financial Planning Models

Financial planning models do not always ask the right questions. A primary reason is that they tend to rely on accounting relationships and not financial relationships. In particular, the three basic elements of firm value tend to get left out, namely, cash flow size, risk, and timing. Because of this, financial planning models sometimes do not produce output that gives the user many meaningful clues about what strategies will lead to increases in value. Instead, they divert the user's...

The Agency Problem And Control Of The Corporation

We've seen that the financial manager acts in the best interests of the stockholders by taking actions that increase the value of the stock. However, we've also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders Put another way, might not management pursue its own goals at the...

In Recent Years Large Financial Institutions Such As Mutual Funds And Pension Funds Have Been Becoming The Dominant

Agency relationship exists in the corporate form of organization In this context, what kinds of problems can arise 7. Primary versus Secondary Markets You've probably noticed coverage in the financial press of an initial public offering IPO of a company's securities. Is an IPO a primary-market transaction or a secondary-market transaction 8. Auction versus Dealer Markets What does it mean when we say the New York Stock Exchange is an auction market How are auction markets different from dealer...