- Calculate two EBIT–EPS coordinates for each of the structures by selecting any
two EBIT values and finding their associated EPS values.
- Plot the two capital structures on a set of EBIT–EPS axes.
- Indicate over what EBIT range, if any, each structure is preferred.
- Discuss the leverage and risk aspects of each structure.
- If the firm is fairly certain that it’s EBIT will exceed $75,000, which structure
would you recommend? Why?
P14–3 Residual dividend policy As president of Young’s of California, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks about the company’s dividend policy. In fact, the stockholder has asked you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you do know the following:
(1) The company follows a residual dividend policy.
(2) The total capital budget for next year is likely to be one of three amounts,
depending on the results of capital budgeting studies that are currently under
way. The capital expenditure amounts are $2 million, $3 million, and
$4 million.
(3) The forecasted level of potential retained earnings next year is $2 million.
(4) The target or optimal capital structure is a debt ratio of 40%.
You have decided to respond by sending the stockholder the best information available
to you.
- Describe a residual dividend policy.
- Compute the amount of the dividend (or the amount of new common stock needed) and the dividend payout ratio for each of the three capital expenditure amounts.
- Compare, contrast, and discuss the amount of dividends (calculated in part b) associated with each of the three capital expenditure amounts.
P14–15 Stock split versus stock dividend: Firm Mammoth Corporation is considering a 3-for-2 stock split. It currently has the stockholders’ equity position shown. The current stock price is $120 per share. The most recent period’s earnings available for common stock are included in retained earnings.
Preferred stock $ 1,000,000
Common stock (100,000 shares at $3 par) 300,000
Paid-in capital in excess of par 1,700,000
Retained earnings 10,000,000
Total stockholders’ equity $13,000,000
- What effects on Mammoth would result from the stock split?
- What change in stock price would you expect to result from the stock split?
- What is the maximum cash dividend per share that the firm could pay on common stock before and after the stock split? (Assume that legal capital includes all paid-in capital.)
- Contrast your answers to parts a through c with the circumstances surrounding a
50% stock dividend.
- Explain the differences between stock splits and stock dividends.
P15–4 Aggressive versus conservative seasonal funding strategy Dynabase Tool has forecast its total funds requirements for the coming year as shown in the following table.
Month Amount Month Amount
January $2,000,000 July $12,000,000
February 2,000,000 August 14,000,000
March 2,000,000 September 9,000,000
April 4,000,000 October 5,000,000
May 6,000,000 November 4,000,000
June 9,000,000 December 3,000,000
- Divide the firm’s monthly funds requirement into (1) a permanent component and (2) a seasonal component, and find the monthly average for each of these components.
- Describe the amount of long-term and short-term financing used to meet the total funds requirement under (1) an aggressive funding strategy and (2) a conservative funding strategy. Assume that, under the aggressive strategy, long-term funds finance permanent needs and short-term funds are used to finance seasonal needs.
- Assuming that short-term funds cost 5% annually and that the cost of long-term funds is 10% annually, use the averages found in part a to calculate the total cost of each of the strategies described in part b. Assume that the firm can earn 3% on any excess cash balances.
- Discuss the profitability–risk trade-offs associated with the aggressive strategy and those associated with the conservative strategy.
P15–5 EOQ analysis Tiger Corporation purchases 1,200,000 units per year of one component. The fixed cost per order is $25. The annual carrying cost of the item is 27% of its $2 cost.
- Determine the EOQ if (1) the conditions stated above hold, (2) the order cost is zero rather than $25, and (3) the order cost is $25 but the carrying cost is $0.01.
- What do your answers illustrate about the EOQ model? Explain.
P15–10 Relaxation of credit standards Lewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a result of the proposed relaxation, sales are expected to increase by 10% from 10,000 to 11,000 units during the coming year, the average collection period is expected to increase from 45 to 60 days, and bad debts are expected to increase from 1% to 3% of sales. The sale price per unit is $40, and the variable cost per unit is $31. The firm’s required return on
equal-risk investments is 25%. Evaluate the proposed relaxation, and make a recommendation to the firm. (Note: Assume a 365-day year.)
P16–18 Accounts receivable as collateral, cost of borrowing Maximum Bank has analyzed the accounts receivable of Scientific Software, Inc. The bank has chosen eight accounts totaling $134,000 that it will accept as collateral. The bank’s terms include a lending rate set at prime plus 3% and a 2% commission charge. The prime rate currently is 8.5%.
- The bank will adjust the accounts by 10% for returns and allowances. It then will lend up to 85% of the adjusted acceptable collateral. What is the maximum amount that the bank will lend to Scientific Software?
- What is Scientific Software’s effective annual rate of interest if it borrows
$100,000 for 12 months? For 6 months? For 3 months? (Note: Assume a
365-day year and a prime rate that remains at 8.5% during the life of the loan.)
P16–20 Inventory financing Raymond Manufacturing faces a liquidity crisis: It needs a loan of $100,000 for 1 month. Having no source of additional unsecured borrowing, the firm must find a secured short-term lender. The firm’s accounts receivable are quite low, but its inventory is considered liquid and reasonably good collateral. The book value of the inventory is $300,000, of which $120,000 is finished goods. (Note: Assume
a 365-day year.)
(1) City-Wide Bank will make a $100,000 trust receipt loan against the finished goods inventory. The annual interest rate on the loan is 12% on the outstanding loan balance plus a 0.25% administration fee levied against the $100,000 initial loan amount. Because it will be liquidated as inventory is sold, the average amount owed over the month is expected to be $75,000.
(2) Sun State Bank will lend $100,000 against a floating lien on the book value of inventory for the 1-month period at an annual interest rate of 13%.
(3) Citizens’ Bank and Trust will lend $100,000 against a warehouse receipt on the finished goods inventory and charge 15% annual interest on the outstanding loan balance. A 0.5% warehousing fee will be levied against the average amount borrowed. Because the loan will be liquidated as inventory is sold, the average loan balance is expected to be $60,000.
- Calculate the dollar cost of each of the proposed plans for obtaining an initial loan amount of $100,000.
- Which plan do you recommend? Why? c. If the firm had made a purchase of $100,000 for which it had been given terms of 2/10 net 30, would it increase the firm’s profitability to give up the discount and not borrow as recommended in part b? Why or why not?
