Answers to Chapter Review and Self Test Problems

18.1 Readata has a debt-equity ratio of .60/.40 = 1.50. If the entire $5,000 in earnings were reinvested, then $5,000 X 1.50 = $7,500 in new borrowing would be needed to keep the debt-equity ratio unchanged. Total new financing possible without external equity is thus $5,000 + 7,500 = $12,500.

If planned outlays are $12,000, then this amount will be financed with 40 percent equity. The needed equity is thus $12,000 X .40 = $4,800. This is less than the $5,000 in earnings, so a dividend of $5,000 - 4,800 = $200 will be paid.

18.2 The market value of the equity is $2,500. The price per share is $25, so there are 100 shares outstanding. The cash dividend would amount to $500/100 = $5 per share. When the stock goes ex dividend, the price will drop by $5 per share to $20. Put another way, the total assets decrease by $500, so the equity value goes down by this amount to $2,000. With 100 shares, the new stock price is $20 per share. After the dividend, EPS will be the same, $2.50, but the PE ratio will be $20/2.50 = 8 times.

With a repurchase, $500/25 = 20 shares will be bought up, leaving 80. The equity will again be worth $2,000 total. With 80 shares, this is $2,000/80 = $25 per share, so the price doesn't change. Total earnings for Gothic must be $2.50 X 100 = $250. After the repurchase, EPS will be higher at $250/80 = $3.125. The PE ratio, however, will be $25/3.125 = 8 times.

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