FM Assignment Meeting

Meeting 7
Ch 13: 13-2, 13-3, 13-4
13-2
What is the possible agency conflict between inside owner/managers and outside shareholders?
Answer:
One of possible agency conflict is when the managers act on their own self-interest and is not aligned
with the shareholders interest. Another possible source of agency conflict between managers and
shareholders is the consumption of or indulgence in perks.

13-3
What are some possible agency conflicts between borrowers and lenders?
Answer:
Borrowers may make decisions that are detrimental to the lender after the loan is originated. Borrowers
may, for instance, invest in high-risk projects.

13-4
What are some actions an entrenched management might take that would harm shareholders?
Answer:

1. Managers may be unwilling to invest the time and effort necessary to maximize firm value.
2. Managers may divert corporate resources to their own benefit rather than that of shareholders.
3. Managers may avoid making difficult but value-enhancing decisions that would jeopardize the
company's relationships.
4. Managers may take on too much risk or not enough risk.
5. If a company generates positive free cash flow, the manager may "stockpile" it in the form of
marketable securities rather than returning it to shareholders.
6. Managers may not disclose all information desired by investors.

Ch 14: 14-7, 14-9, 14-10

14-7
Suppose you own 2,000 common shares of Laurence Incorporated. The EPS is $10.00, the DPS is $3.00,
and the stock sells for $80 per share. Laurence announces a 2-for-1 split. Immediately after the split,
how many shares will you have, what will the adjusted EPS and DPS be, and what would you expect
the stock price to be?
Answer:
Before stock split After stock split (2-for-1 split)
2,000 common shares 2,000*2 = 4,000 common shares
$80 per share $80/2 = $40 per share
EPS = $10.00 EPS = $10/2 = $5
DPS = $3.00 DPS = $3/2 = $1.5

14-9
Harris Company must set its investment and dividend policies for the coming year. It has three
independent projects from which to choose, each of which requires a $3 million investment. These
projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and
costs of capital are as follows:
Project A: Cost of capital = 17%; IRR = 20%
Project B: Cost of capital = 13%; IRR = 10%
Project C: Cost of capital = 7%; IRR = 9%
Harris intends to maintain its 35% debt and 65% common equity capital structure, and its net income is
expected to be $4,750,000. If Harris maintains its residual dividend policy (with all distributions in the
form of dividends), what will its payout ratio be?
Answer:
$3 million of investment each project
Capital structure = 35% debt and 65% common equity
Expected net income = $4,750,000

Project A and C will be accepted as their IRR > Cost of capital

Total investment = $3 million *2 = $6 million
Equity = Net income – Dividend
Dividend = Net income – Equity
= 4,750,000 – (65% * 6,000,000)
= 850,000
Dividend payout ratio = dividend / income
= 850,000 / 4,750,000
= 17.894%

14-10
Boehm Corporation has had stable earnings growth of 8% a year for the past 10 years, and in 2019
Boehm paid dividends of $4 million on net income of $10 million. However, net income is expected to
grow by 28% in 2020, and Boehm plans to invest $7.5 million in a plant expansion. This one-time
unusual earnings growth won’t be maintained, though, and after 2019 Boehm will return to its previous
8% earnings growth rate. Its target debt ratio is 34%. Boehm has 1 million shares of stock.

a. Calculate Boehm’s dividends per share for 2020 under each of the following policies:
(1) Its 2020 dividend payment is set to force dividends to grow at the long-run growth rate in
earnings.
Answer:
Long-run growth rate = 8%
2019 Dividend = $4 million
2020 Dividend = $4 million * (1+0.08)
= $4,320,000
DPS = $4,320,000 / 1,000,000 = $4.32 per share

(2) It continues the 2019 dividend payout ratio.

Answer:
2019 dividend payout ratio = dividend / net income
= $4 million / $10 million
= 0.4

2020 Dividend using 2019 payout ratio

2020 dividend = 2019 payout ratio * 2020 net income
 = 0.4 * 12,800,000
= 5,120,000
DPS = 5,120,000 / 1000,000 = $5.12 per share

(3) It uses a pure residual policy with all distributions in the form of dividends (34% of the
$7.5 million investment is financed with debt).
Answer:
Net income 2020 = 12,800,000
Capital structure: @ investment $7.5 million
Debt 34% = 2,550,000
Equity 66% = 4,950,000
Distribution = Net income – retained earnings needed to finance new investment
= 12,800,000 – 4,950,000
= 7,850,000
DPS = 7,850,000 / 1,000,000 = $7.85 per share

(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on
the long-run growth rate and the extra dividend being set according to the residual policy.
Answer:
Distribution = $7.85 per share
Dividend based on long-run growth rate (Regular) = $4.32 per share
Extra (DPS)= Distribution – dividend (based on long-run growth rate)
= 7.85 – 4.32
= $3.53 per share

b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed,
but justify your answer.
Answer:
The company should implement a distribution policy that maximizes shareholder value while
allowing for expansion. Stockholders prefer companies that pay higher dividends because
higher returns make the extra dividend policy more lucrative. If the company wants to expand
in the future, it can keep the same dividend policy as in 2019.
The dividend policy of additional dividends can be recommended because it maximizes
shareholder benefit. Alternatively, if the company's objective is to retain earnings, the
company's existing dividend policy for 2019 can be used.

Meeting 8
Ch 15: 15-8, 15-9, 15-12
15-8
Lee Manufacturing’s value of operations is equal to $900 million after a recapitalization. (The firm had
no debt before the recap.) Lee raised $300 million in new debt and used this to buy back stock. Lee had
no short-term investments before or after the recap. After the recap, wd = 1/3. The firm had 30 million
shares before the recap. What is P (the stock price after the recap)?
Answer:
Value of Operation = $900 million
30 million of shares before recap
Even after the recap, the number of shares remains unchanged because the company has not issued debt
or equity. As a result, the number of shares is unchanged.
P = value of operation / nprior
P = 900/ 30
P = $30

15-9
Dye Trucking raised $150 million in new debt and used this to buy back stock. After the recap, Dye’s
stock price is $7.50. If Dye had 60 million shares of stock before the recap, how many shares does it
have after the recap?
Answer:
Dnew = $150 million
Pnew = $7.5
nprior = 60 million
npost = nprior – (Dnew – Dold) / Pprior
= 60 – (150/ 7.5)
= 60 – 20
= 40 million shares of stock

15-12
Pettit Printing Company (PPC) has a total market value of $100 million, consisting of 1 million shares
selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company’s
EBIT is $13.24 million, and its tax rate is 15%. Pettit can change its capital structure by either increasing
its debt to 70% (based on market values) or decreasing it to 30%. If it decides to increase its use of
leverage, it must call its old bonds and issue new ones with a 12% coupon. If it decides to decrease its
leverage, it will call its old bonds and replace them with new 8% coupon bonds. The company will sell
or repurchase stock at the new equilibrium price to complete the capital structure change.
PPC expects no growth in its EBIT, so g L is zero. Its current cost of equity, rs, is 14%. If it
increases leverage, rs will be 16%. If it decreases leverage, rs will be 13%. What is the firm’s WACC
and total corporate value under each capital structure?
Answer:
T = 15%
EBIT = $13.24 million

30% debt 50% debt 70% debt

wd 30% 50% 70%
rd 8% 10% 12%
we 70% 50% 30%
rs 13% 14% 16%

Ch 16: 16-9, 16-12, 16-15

16-9
Grunewald Industries sells on terms of 2/10, net 40. Gross sales last year were $4,562,500 and accounts
receivable averaged $437,500. Half of Grunewald’s customers paid on the 10th day and took discounts.
What are the nominal and effective costs of trade credit to Grunewald’s non-discount customers? (Hint:
Calculate daily sales based on a 365-day year, calculate the average receivables for discount customers,
and then find the DSO for the non-discount customers.)
Answer:
Nominal cost of credit = (discount rate / (1 – discount rate))* (365 / number of days)
= (2%/ (1 – 2%)* (365/ 50)
= 14.89%

Effective cost of trade credit = (1+ discount rate / (1 – discount rate)(365/ number of days) – 1
= (1+ (2%/(1-2%))(365/50) – 1
= 1.02047.3 – 1
= 15.89%

16-12
Strickler Technology is considering changes in its working capital policies to improve its cash flow
cycle. Strickler’s sales last year were $3,250,000 (all on credit), and its net profit margin was 7%. Its
inventory turnover was 6.0 times during the year, and its DSO was 41 days. Its annual cost of goods
sold was $1,800,000. The firm had fixed assets totaling $535,000. Strickler’s payables deferral period
is 45 days

a. Calculate Strickler’s cash conversion cycle.

Answer:
Cash conversion cycle (CCC) =ICP+ACP-PDP
Inventory $300,000.00 =COGS/Inventory turnover
COGS per day $4,931.51 =COGS/365
Inventory Conversion Period 60.83 days
CCC 56.83 days
b. Assuming Strickler holds negligible amounts of cash and marketable securities, calculate its
total assets turnover and ROA.
Answer:

c. Suppose Strickler’s managers believe the annual inventory turnover can be raised to 9 times
without affecting sale or profit margins. What would Strickler’s cash conversion cycle, total
assets turnover, and ROA have been if the inventory turnover had been 9 for the year?
Answer:
16-15
Suppose a firm makes purchases of $3.65 million per year under terms of 2/10, net 30, and takes
discounts.

a. What is the average amount of accounts payable net of discounts? (Assume the $3.65 million
of purchases is net of discounts—that is, gross purchases are $3,724,489.80, discounts are
$74,489.80, and net purchases are $3.65 million.)
Answer:
Average accounts payable = purchase/ 365 *credit period
= $3,65/ 365 * 10
= $100,000

b. Is there a cost of the trade credit the firm uses?

Answer:
No, the firm is not using cost of trade credit at the moment; instead, the firm is using free trade
credit, which means that no additional amount will be paid to creditors if the payment is made
within the credit limit.
c. If the firm did not take discounts but did pay on the due date, what would be its average payables
and the nominal and effective costs of this non-free trade credit?
Answer:

d. What would be the firm’s nominal and effective costs of not taking discounts if it could stretch
its payments to 40 days?
Answer:
Cost per period 2.04%
Discount percentage 2%
DSO 40 days
Discount period 10 days
Number of periods per year 12.17 =365/(days sales outstanding - discount period)
Nominal Cost of Trade Credit 24.82% =Cost per period * Number of periods per year
Effective annual rate 27.85% =(1+r)^n - 1