Problems and Questions

1. JLChem Corporation, a chemical manufacturing firm with changing investment opportunities, is considering a major change in dividend policy. It currently has 50 million shares outstanding and pays an annual dividend of $2 per share. The firm current and projected income statement are provided below (in millions):
Current Projected Next Yr
EBITDA 1200 1350
- Depreciation 200 250
EBIT 1000 1100
- Interest Expense 200 200
EBT 800 900
- Taxes 320 360
Net Income 480 540

The firm's current capital expenditure is $ 500 million. It is considering five projects for the next year:
Project Investment Beta IRR (using cashflows to equity)
A $190 mil 0.6 12.0%
B $200 mil 0.8 12.0%
C $200 mil 1.0 14.5%
D $200 mil 1.2 15.0%
E $100 mil 1.5 20.0%

The firm's current beta is 1.0, and the current T. Bond rate is 8.5%. The firm expects working capital to increase $50 million both this year and next. The firm plans to finance its net capital expenditures and working capital needs with 30% debt.

a. What is the firm's current payout ratio?

b. What proportion of its current free cash flow to equity is it paying out as dividends?

c. What would your projected capital expenditure be for next year (i.e Which of the five projects would you accept and why)?

d. How much cash will the company have available to pay out as dividends next year? (What is the maximum amount the company can pay out as dividends? )

e. Would you pay out this maximum amount as dividends? Why or why not? What other considerations would you bring to this decision?

f. JKL Corporation currently has a cash balance of $100 million (after paying the current year's dividends). If it pays out $125 million as dividends next year, what will its projected cash balance be at the end of the next year?

2. GL Corporation, a retail firm, is making a decision on how much it should pay out to its stockholders. It has $100 million in investible funds. The following information is provided about the firm:

(a) It has 100 million shares outstanding, each share selling for $15. The beta of the stock is 1.25 and the riskfree rate is 8%. The expected return on the market is 16%.

(b) The firm has $ 500 million of debt outstanding. The marginal interest rate on the debt is 12%.

(c) The corporation's tax rate is 50%.

(e) The firm has the following investment projects:
Project Investment After-Tax Return on capital
A 15 million 27%
B 10 million 20%
C 25 million 16%
D 20 million 14%
E 30 million 12%

The firm plans to finance all its investment needs at its current debt ratio.

(i) Should the company return money to its stockholders?

(ii) If so, how much should be returned to stockholders?

3. InTech Corporation, a computer software firm which has never paid dividends before is considering whether it should start doing so. This firm has a cost of equity of 22% and a cost of debt of 10% (the tax rate is 40%). The firm has $100 million in debt outstanding and 50 million shares outstanding, selling for $10 per share. The firm currently has net income of $90 million and depreciation charges of $10 million. It also has the following projects available:
Project Initial Investment EBIT Depreciation Lifetime Salvage
1 $10 million $ 1 mil $500,000 5 years $2.5 mil
2 $40 million $ 15 mil $ 1 million 10 years $10 mil
3 $50 million $ 5 mil $ 1 million 10 years $10 mil

The firm plans to finances its future capital investment needs using 20% debt.

a. Which of these projects should the firm accept?

b. How much (if any) should the firm pay out as dividends?

4. LimeAde Corporation, a large soft drink manufacturing firm, is faced with the decision of how much to pay out as dividends to its stockholders. It expects to have a net income of $ 1000 (after depreciation of $500), and it has the following projects:
Project Initial Investment Beta IRR (to equity investors)
A $ 500 2.0 21%
B $600 1.5 20%
C $ 500 1.0 12%

The firm's beta is 1.5 and the current risk-free rate is 9%. The firm plans to finance net capital expenditures (cap ex -depreciation) and working capital with 20% debt. The firm also has current revenues of $5000, which it expects to grow at 8 %. Working capital will be maintained at 25% of revenues. How much should the firm return to its stockholders as a dividend?

5. NoLone Corporation, an all-equity manufacturing firm, has net income of $100 million currently and expects this number to grow at 10% a year for the next three years. The firm's working capital increased by $10 million this year and is expected to increase by the same dollar amount each of the next three years. The depreciation is $50 million and is expected to grow 8% a year for the next three years. Finally, the firm plans to invest $60 million in capital expenditure for each of the next three years. The firm pays 60% of its earnings as dividends each year. RYBR has a cash balance currently of $50. Assuming that the cash does not earn any interest, how much would you expect to have as a cash balance at the end of the third year?

6. Boston Turkey is a publicly traded firm, with the following income statement and balance sheet from its most recent financial year:

Income Statement
Revenues $ 1,000,000
- Expenses $ 400,000
- Depreciation $ 100,000
EBIT $ 500,000
- Interest Expense $ 100,000
Taxable Income $ 400,000
- Tax $ 160,000
Net Income $ 240,000

Assets Liabilities
Property, Plant & Equipment $ 1,500,000 Accounts Payable $ 500,000
Land & Buildings $ 500,000 Long Term Debt $ 1,000,000
Current Assets $ 1,000,000 Equity (100,000 shares) $ 1,500,000
Total $ 3,000,000 Total $ 3,000,000

Boston Turkey expects its revenues to grow 10% next year and its expenses to remain at 40% of revenues. The depreciation and interest expenses will remain unchanged at $100,000 next year. The working capital, as a percentage of revenue, will also remain unchanged next year.

The managers of Boston Turkey claim to have several projects available to choose from next year, in whichthey plan to invest the funds from operations, and they suggest that the firm really should not be paying dividends. The projects have the following characteristics:
Project Equity Investment Expected Annual CF to Equity Beta
A $ 100,000 12,500 1.00
B $ 100,000 14,000 1.50
C $ 50,000 8,000 1.80
D $ 50,000 12,000 2.00

The treasury bill rate is 3%, and the treasury bond rate is 6.25%. The firm plans to finance 40% of its future net capital expenditures (Cap Ex - Depreciation) and working capital needs with debt.

a. How much can the company afford to pay in dividends next year?

b. Now assume that the firm actually pays out $1.00 per share in dividends next year. The current cash balance of the firm is $150,000. How much will the cash balance of the firm be at the end of next year, after the payment of the dividend?

7. Z-Tec Corporation, a firm providing Internet services, reported net income of $ 10 million in the most recent year, while making $ 25 million in capital expenditures (depreciation was $ 5 million). The firm had no working capital needs and uses no debt.

a. Can the firm afford to pay out dividends right now? Why or why not?

b. Assuming net income grows 40% a year and that net capital expenditures grow 10% a year, when will the firm be in a position to pay dividends?

8. You are analyzing the dividend policy of Conrail, a major railroad, and you have collected the following information from the last 5 years ñ
Net Income
Capital Expenditure
Non-cash Working Capital
$ 240
$ 314
$ 307
$ 35
$ 70
$ 282
$ 466
$ 295
$ (110)
$ 80
$ 320
$ 566
$ 284
$ 215
$ 95
$ 375
$ 490
$ 278
$ 175
$ 110
$ 441
$ 494
$ 293
$ 250
$ 124

The average debt ratio during this period was 40% and the total non-cash working capital at the end of 1990 was $ 10 million.

a. Estimate how much Conrail could have paid in dividends during this period.

b. If the average return on equity during the period was 13.5%, and Conrail had a beta of 1.25, what conclusions would you draw about Conrailís dividend policy? (The average T.Bond rate during the period was 7%, and the average return on the market was 12.5% during the period)

9. Assume now that you have been asked to forecast cash flows that you will have available to repurchase stock and pay dividends during the next 5 years for Conrail. In making these forecasts, you can assume the following ñ

a. Estimate how much cash Conrail will have available to pay dividends or repurchase stocks over the next 5 years.

b. How will the perceived uncertainty associated with these cash flows affect your decision on dividends and equity repurchases?

10. Cracker Barrel, which operates restauarants and gift stores, is reexamining its policy of paying minimal dividends. In 1995, Cracker Barrel reported net income of $ 66 million; it had capital expenditures of $ 150 million in that year and claimed depreciation of only $ 50 million. The working capital in 1995 was $ 43 million on sales of $ 783 million. Looking forward, Cracker Barrel expects the following:

a. Estimate how much cash Cracker Barrel would have available to pay out to its stockholders over the next 5 years

b. How would your answer change, if the firm plans to increase its leverage by borrowing 25% of its net capital expenditure and working capital needs?

11. Assume that Cracker Barrel wants to continue with its policy of not paying dividends. You are the CEO of Cracker Barrel and have been confronted by dissident stockholders, demanding to know why you are not paying out your FCFE (estimated in the previous problem) to your stockholders. How would you defend your decision? How receptive will stockholders be to your defense? Would it make any difference that Cracker Barrel has earned a return on equity of 25% over the previous five years, and that its beta is only 1.2?

12. Manpower Corporation, which provides non-government emplyments services in the United States, reported net income of $ 128 million in 1995. It had capital expenditures of $ 50 million and depreciation of $ 24 million in 1995, and its working capital was $ 500 million (on revenues of $ 5 billion). The firm has a debt ratio of 10%, and plans to maintain this debt ratio. Income, cap ex, depreciation and revenues are all expected to grow 10% in 1996; working capital as a percent of revenues remains unchanged.

a. Estimate how much Manpower Corporation will have available to pay out as dividends next year.

b. The current cash balance is $ 143 million. If Manpower Corporation is expected to pay $ 12 million in dividends next year and repurchase no stock, estimate the expected cash balance at the end of the next year.

13. How would your answers to the previous problem change if Manpower Corporation plans to pay off its outstanding debt of $ 100 million next year and become a debt-free company?

14. You are an institutional investor and have the collected the following information on five maritime firms in order to assess their dividend policies:
Company FCFE Dividends Paid ROE Beta
Alexander & Brown $ 55 $ 35 8% 0.80
American President $ 60 $ 12 14.5% 1.30
OMI Corporation - $ 15 $ 5 4.0% 1.25
Overseas Shipholding $ 20 $ 12 1.5 % 0.90
Sea Containers - $ 5 $ 8 14% 1.05

The average riskfree rate during the period was 7% and the average return on the market was 12%.

a. Assess which of these firms you would pressure to pay more in dividends.

b. Which of the firms would you encourage to pay less in dividends?

c. How would you modify this analysis to reflect your expectations about the future of the entire sector?

15. You are analyzing the dividend policy of Black and Decker, a manufacturer of tools and appliances. The following table summarizes the dividend payout ratios, yields and expected growth rates of other firms in the waste disposal business.
Payout Ratio
Dividend Yield
Ex. Growth
Fedders Corporation
Maytag Corporation
National Presto
Toro Corporation
Whirlpool Corp.
Black & Decker

a. Compare Black and Deckerís dividend policy to those of its peers, using the average dividend payout ratios and yields.

b. Do the same comparison, controlling for differences in expected growth.

16. The following regression was run using all NYSE firms in 1995

YIELD = 0.0478 - 0.0157 BETA + 0.0000008 MKTCAP + 0.6797 DBTRATIO + 0.0002 ROE - 0.09 NCEX/TA R2= 12.88%

where BETA = Beta of the stock

MKTCAP = Market Value of Equity + Book Value of Debt

DBTRATIO = Book Value of Debt / MKTCAP

ROE = Return on Equity in 1994

NCEX/TA = (Capital Expenditures - Depreciation) / Total Assets

The corresponding values for Black and Decker, in 1995, were as follows:

Beta = 1.30

MKTCAP = $ 5,500 million


ROE = 14.5%

NCEX/TA = 4.00%

Black and Decker had a dividend yield of 1.3% and a dividend payout ratio of 24% in 1995.

a. Estimate the dividend yield for Black and Decker, based upon the regression.

b. Why might your answer be different, using this approach, than the answer to the prior question, where you used only the comparable firms?

17. Handy and Harman, a leading fabricator of precious metal alloys, pays out only 23% of its earnings as dividends. The average dividend payout ratio for metal fabricating firms is 45%. The average growth rate in earnings for the entire sector is 10% (Handy and Harman is expected to grow 23%). Should Handy and Harman pay more in dividends just to get closer to the average payout ratio? Why or why not?