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Solutions - Midterm II Review

# Solutions - Midterm II Review - UNIVERSITY OF NORTH...

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U NIVERSITY OF N ORTH C AROLINA A T C HAPEL H ILL K ENAN -F LAGLER B USINESS S CHOOL B USI 408: C ORPORATE F INANCE S OLUTIONS TO R EVIEW P ROBLEM SET #2 P ROF . A RZU O ZOGUZ F ALL 2008 1. DFB, Inc. expects earnings this year of \$5 per share, and it plans to pay \$3 dividend to shareholders. DFB will retain \$2 per share of its earnings to reinvest in new project that have an expected return of 15% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments in the future and will not change its number of shares outstanding. a. What growth rate of earnings would you forecast for DFB? ࢍ ൌ ࢘ࢋ࢚ࢋ࢔࢚࢏࢕࢔ ࢘ࢇ࢚࢏࢕ ൈ ࢘ࢋ࢚࢛࢘࢔ ࢕࢔ ࢏࢔࢜ࢋ࢙࢚࢓ࢋ࢔࢚ ൌ ൈ ૙. ૚૞ ൌ ૙. ૙૟ ൌ ૟% b. If DFB’s cost of equity capital is 12%, what price would you estimate for DFB stock? ࡰ࢏࢜ െ ࢍ \$૜ ૙. ૚૛ െ ૙. ૙૟ ൌ \$૞૙ c. Suppose instead that DFB paid a dividend of \$4 per share this year, and retained only \$1 per share in earnings. If DFB maintains a higher payout rate in the future, what stock price would you estimate for the firm now? Should DFB raise its dividend? Assuming that the expected return on investment is still 15%, the lower retention rate translates into lower growth: ࢍ ൌ ࢘ࢋ࢚ࢋ࢔࢚࢏࢕࢔ ࢘ࢇ࢚࢏࢕ ൈ ࢘ࢋ࢚࢛࢘࢔ ࢕࢔ ࢏࢔࢜ࢋ࢙࢚࢓ࢋ࢔࢚ ൌ ൈ ૙. ૚૞ ൌ ૙. ૙૜ ൌ ૜% Given this expected growth rate, next year’s dividend will be \$4×1.03 = \$4.12, and the stock price will be: ࡰ࢏࢜ െ ࢍ \$૝. ૚૛ ૙. ૚૛ െ ૙. ૙૜ ൌ \$૝૞. ૠૡ No, projects are positive NPV (return exceeds cost of capital), so don’t raise dividend.

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2. Cooperton Mining just announced it will cut its dividend from \$4 to \$2.50 per share and use the extra funds to expand. Prior to the announcement, Cooperton’s dividends were expected to grow at a 3% rate, and its share price was \$50. With the planned expansion, Cooperton’s dividends are expected to grow at a 5% rate. What share price would you expect after the announcement? Is the expansion a positive-NPV investment? Since the price was \$50 prior to the announcement with an expected growth rate of 3%, we can solve for Cooperton’s cost of equity capital: ࡼ ൌ ࡰ࢏࢜ െ ࢍ ൌ ૞૙ ൌ ૝. ૙૙ െ ૙. ૙૜ ՜ ࢘ ൌ ૙. ૚૚ ൌ ૚૚% After the announcement, ࡼ ൌ ࡰ࢏࢜ െ ࢍ ૛. ૞૙ ૙. ૚૚ െ ૙. ૙૞ ൌ \$૝૚. ૟ૠ In this case, cutting the dividend will reduce the stock price to \$41.67. The move to cut the dividend and to expand is not positive NPV. Do not do it. 3. Colgate-Palmolive Company has just paid an annual dividend of \$0.96. Analysts are predicting an 11% per year growth rate in earnings over the next five years.
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Solutions - Midterm II Review - UNIVERSITY OF NORTH...

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