Week 06 Example Problems

1. Firm A had the following selected items on its balance sheet:

How would each of these accounts appear after:

a. A cash dividend of $1 per share?

b. A 5 percent stock dividend (fair market value is $100 per share)?

c. A one-for-two reverse split?

Solution:

a. After the dividend is declared, retained earnings are reduced and current liabilities are increased by the amount of the dividend, in this case, 2,000,000 x $1. When the dividend is paid, cash and current liabilities are reduced by $2,000,000. The net effect is that cash becomes $26,000,000 and retained earnings decline to $60,000,000.

b. A stock dividend does not affect a firm's assets or liabilities. It is a recapitalization that transfers an entry from retained earnings to common stock and additional paid-in capital.

In this example, the 5% stock dividend results in 100,000 shares (2,000,000 x .05) being issued. They have a market value of $10,000,000 (100,000 x $100) so retained earnings are reduced to $52,000,000. $5,000,000 (100,000 x $50 par value). Retained earnings are reduced to $52,000,000. $5,000,000 is credited to common stock (for a total of $105,000,000). The remaining $5,000,000 is credited to additional paid-in capital (for a total of $15,000,000).

c. A stock split does not affect the firm's assets or liabilities. It only alters the number of shares, their par value, and the price of the stock. In this case (a one for two reverse stock split), two old shares become one new share, and the par value of the new share is doubled.

2. The dividend-growth model may be used to value a stock:

g)

-

k

(

g))

1

(

(

0

¸

+

=

D

V

a. What is the value of a stock if:

D0= $2

k = 10%

g = 6%

b. What is the value of the stock if the dividend is increased to $3 and the other variables remain constant?

c. What is the value of this stock if the required return declines to 7.5 percent and the other variables remain constant?

d. What is the value of this stock if the growth rate declines to 4 percent and the other variables remain constant?

e. What is the value of this stock if the dividend is increased to $2.30, the growth rate declines to 4 percent, and the required return remains 10 percent?

Solution:

a.

53

$

04

.

12

.

2

)

06

.

1

(.

))

06

.

1

(

2

(

=

¸

=

-

¸

+

=

V

V

V

b.

50

.

79

$

04

.

18

.

3

)

06

.

1

(.

))

06

.

1

(

3

(

=

¸

=

-

¸

+

=

V

V

V

c.

33

.

141

$

)

06

.

075

(.

))

06

.

1

(

2

($

=

-

¸

+

=

V

V

d.

67

.

34

$

)

04

.

10

(.

))

04

.

1

(

2

($

=

-

¸

+

=

V

V

e.

87

.

39

$

)

04

.

10

(.

))

04

.

1

(

30

.

2

($

=

-

¸

+

=

V

V

3. Last year Artworks, Inc. paid a dividend of $3.50. You anticipate that the company's growth rate is 10 percent and have a required rate of return of 15 percent for this type of equity investment.

What is the maximum price you would be willing to pay for the stock?

Solution:

77

$

05

.

85

.

3

)

1

.

1

(.

))

1

.

1

(

50

.

3

($

=

¸

=

-

¸

+

=

V

V

V

4. Your broker recommends that you purchase Good Mills at $30. The stock pays a $2.20 dividend, which (like its per share earnings) is expected to grow annually at 8 percent.

a. If you want to earn 15 percent on your funds, is this stock a good buy?

b. What if the Good Mills dividend was only $1.00. How would this affect the valuation?

Solution:

a.

94

.

33

$

07

.

376

.

2

)

08

.

15

(.

))

08

.

1

(

20

.

2

($

=

¸

=

-

¸

+

=

V

V

V

Since the valuation of the stock is over the current price of $30, it looks undervalued and a good buy.

b.

43

.

15

$

07

.

08

.

1

)

08

.

15

(.

))

08

.

1

(

00

.

1

($

=

¸

=

-

¸

+

=

V

V

V

$15.43 value, so it now doesn't look like a good buy.

Adapted from:

Mayo, H. (2007). Basic finance: An introduction to financial institutions, investments & management. United States: Thomson South-Western.

_1237285403.unknown

_1237979659.unknown

_1237979746.unknown

_1237979802.unknown

_1237285531.unknown

_1237285756.unknown

_1237285413.unknown

_1237284125.unknown

_1237285325.unknown