# Static SS8 Vignette

The management of Static Corporation has been reviewing its capital budget and dividend payment policy for the coming year. The company initiated a quarterly dividend of 0.55 per share several years ago. Static is at its optimal capital structure of 40% debt and 60% equity. The proposed capital budget investments being considered for next year are detailed in the Project Table below. The expected net income for the upcoming year is 8.2 million. Additional information is as follows: Cost of Debt 9.0% Cost of Equity 13.5% Tax Rate 35% Current Stock Price \$105/share Common Shares Outstanding 1.5 million Current EPS \$5.20 Project _____Cost ___________IRR A _________\$5.0 million ______12.5% B _________\$3.1 million ______10.7% C _________\$2.4 million ______14.0% 1. Calculate the percentage payout rate for the current year. a. 5.0% b. 10.6% c. 42.3% 2. Static Company management has opted to use the residual dividend approach for the upcoming year. What percentage of next year’s net income is needed to finance the capital budget? a. 60% b. 77% c. 100% 3. What is the payout ratio using the residual dividend approach? a. 42% b. 40% c. 23% 4. Which of the following statements concerning dividend policy changes is most accurate? a. Dividend stability does not matter. Investors realize that changing investment opportunities results in varying cash flow demands. b. The clientele effect argues that market forces will sort out investor dividend preferences such that a firm’s dividend policy matters little. c. The residual model results in steady dividend payments from year to year. 5. Assume it is three years in the future and Static has introduced policies having a stabilizing effect on the company’s operations. The company is expecting to earn a 13.3 % return on equity into the foreseeable future and maintain a dividend payout ratio of 30%. What internal growth rate can Static expect going forward? a. 13.3% b. 9.3% c. 4.0%

professor tai is that you?

haha - damn - you spotted me

This is too difficult man… CBCCB? Ignore my workings below… Q1. 4*0.55/5.20 =0.4230769230 = C? Q2. EPS1 = 8.2/1.5 = 5.46667 WACC = 0.40*0.09*0.65 + 0.60*0.135 = 0.0234 + 0.081 = 0.1044 = 10.44% (all 3 projects will be chosen for next year) CAPEX = 5+3.1+2.4 = 10.5 10.5*0.60 = 6.3/1.5 = 4.2 needed from endo growth 5.46667-4.2 = 1.26667 dispatched as dividends needed 4.2/ available 5.46667 = percentage of next year’s net income is needed to finance the capital budget = 0.7682922144559 = 77% = B? Q3 DPR = 1.26667/5.46667 = 0.2317077 = C? Q4. C? (not a - because Dividend stability matters a hecka lot, not b - because clientele effect is the effect due to various spectrum of investors liking/ not liking dividend incomes) Q5. 0.133*0.70 = 0.0931 = B?

Q1: .55 * 4 / 5.2 = 42.3% 2. all projects cost = 10.5 million if company finances them and maintains the target d/e – equity required from retained earnings = .6 ( 10.5) = 6.3 million so % of net income = 6.3/ 8.2 = 77% --> b 3. What is the payout ratio using the residual dividend approach? a. 42% b. 40% c. 23% target payout = 1.9 / 8.2 = 23.17 --> C 4. Which of the following statements concerning dividend policy changes is most accurate? a. Dividend stability does not matter. Investors realize that changing investment opportunities results in varying cash flow demands. b. The clientele effect argues that market forces will sort out investor dividend preferences such that a firm’s dividend policy matters little. c. The residual model results in steady dividend payments from year to year. NOT SURE about this one… guess is C. 5. Assume it is three years in the future and Static has introduced policies having a stabilizing effect on the company’s operations. The company is expecting to earn a 13.3 % return on equity into the foreseeable future and maintain a dividend payout ratio of 30%. What internal growth rate can Static expect going forward? a. 13.3% b. 9.3% c. 4.0% (1-.3) * 13.3 = 9.31% --> B

cpk - we have the same answers - CBCCB. And I am not at all sure with Q4

1. Choice “c” is correct. The percentage payout is the annual dividend divided by the EPS. The annual dividend is \$2.20 (\$0.55 x 4) Percentage Payout Rate = \$2.20 / \$5.20 = 42.3% Choice “a” is incorrect. This is the earnings yield (earnings/stock price). Choice “b” is incorrect. This is the quarterly dividend divided by the EPS. 2. Choice “b” is correct. Of the \$8.2 million anticipated net income, 77% (\$6.3 million) is required to finance the capital budget. The capital budget should include all projects with an IRR in excess of the company’s weighted average cost of capital or “hurdle rate.” WACC = 40% x [9.0% x (1 - 0.35)] + 60% x 13.5% = 10.44% The IRR for all three projects exceeds the company’s WACC, so all three should be undertaken. The capital budget will be \$10.5 million (\$5.0 + \$3.1 + \$2.4). The equity requirement will be \$6.3 million (60% x \$10.5 million). \$6.3 million is 77% of the \$8.2 million in anticipated income. The remainder of the financing will come from debt issuance. Choice “a” is incorrect. This is the equity component of the company’s optimal capital structure. Choice “c” is incorrect. This incorrectly assumes that only equity financing will be used. 3. Choice “c” is correct. The residual net income available for dividends is \$1.9 million or 23% of the available net income. The \$1.9 million is equal to the \$8.2 million less the \$6.3 million needed for the capital budget. Of the \$8.2 million anticipated net income, 77% (\$6.3 million) is required to finance the capital budget. The capital budget should include all projects with an IRR in excess of the company’s weighted-average cost of capital or “hurdle rate.” WACC = 40% x [9.0% x (1 - 0.35)] + 60% x [13.5%] = 10.44% The IRR for all three projects exceeds the company’s WACC, so all three should be undertaken. The capital budget will be \$10.5 million (\$5.0 + \$3.1 + \$2.4). The equity requirement will be \$6.3 million (60% x \$10.5 million). \$6.3 million is 77% of the \$8.2 million in anticipated income. The remainder of the financing will come from debt issuance. Choice “a” is incorrect. This is the current year payout ratio, which is not relevant. Choice “b” is incorrect. This is the payout ratio for the upcoming year, assuming the dividend remains at \$2.20 per share. 4. Choice “b” is correct. It is true the clientele effect maintains there is no net effect on firm/share value. However, unstable dividend policies are viewed unfavorably and will affect value. Choice “a” is incorrect. Dividend instability is generally viewed negatively by investors. While cash flow requirements will vary with profitable investment opportunities, shareholders often rely on dividend streams to meet expenses and potential cuts can imply diminishing earning prospects. Choice “c” is incorrect. The residual model gives priority to financing capital projects over dividend payments. Dividend payments can therefore fluctuate (not stay steady) from year to year, depending upon availability of worthwhile projects. 5. Choice “b” is correct. The sustainable (internal, organic, etc.) growth rate, g, is the ROE multiplied by the company’s retention rate. Internal Growth Rate = 13.3%(1 - .30) = 9.3 Choice “a” is incorrect. All of the company’s return on equity does not contribute to internal growth, unless the firm retains 100% of its earnings (no payout). In this case, the 30% payout reduces the internal growth rate. Choice “c” is incorrect. This is the result if the ROE is incorrectly multiplied by the payout ratio. The correct multiplier is 1 - the payout ratio - the retention ratio.

I’m going with CBCBB. I don’t remember reading about the clientele effect but I eliminated the other options. It seems that the residual dividend approach would actually result in volatile payouts depending on the capital budget etc. would it not?

Sweet…I needed a pick me up after bombing the last few vignettes that were posted