Corporate Finance Case Study

3. Randal Flapjack is a retired short-order cook living on a fixed income in the state of Utopia where all financial markets are perfectly efficient. Randal has 20,000 shares of the Sugarcooky Corp., which pays an annualized dividend of $1.00 per share. Sugarcooky sells at a P/E of 10, has maintained a payout ratio of 50% for many years, and has not grown in some time. Management has recently announced that it will reduce Sugarcooky's payout ratio to 25% but expects earnings to grow at 5% from now on.

a. What is Sugarcooky's current price?

b. How much current income is Randal losing as a result of management's action?

c. If Randal keeps his money in Sugarcooky but needs to maintain his current income, how many shares will he have to sell in the first year?

d. What will be the value of his remaining shares at the end of a year if the P/E remains the same? Is his investment growing? Why?

a. Payout ratio = 50%, Dividend = $1.00

EPS = $1/.50 = $2

P = EPS P/E = $20

b. D = $2.00 .25 = $0.50, a reduction of $0.50 per share.

$.50 20,000 = $10,000

c. $10,000 / $20 = 500 shares

d. New EPS = $2 1.05 = $2.10

P = EPS P/E = $2.10 10 = $21

New value = 19,500 $21 = $409,500

Old value = 20,000 $20 = $400,000

Growth in investment =$ 9,500

The stock's value is increasing at 5%, but Randal sold off only 2.5% of his shares, his net investment is therefore growing.

5. The Holderall Rope and Yarn Co. has 2 million common shares outstanding. Its capital structure is two-thirds equity. The firm expects earnings of $10 million next year, and anticipates capital spending of $12 million on projects. How much will the per-share dividend be next year if the firm adheres to a residual dividend policy?

Capital spending is $12M, two-thirds of which will be equity financed, hence $8M of the earnings will be spent on the capital program. The...