Consider a firm F that generates a single cash flow in one year which depends on the state of the economy:
-Boom (probability 1/2) 5m -Recession (probability 1/2) 1m
-F has 2,000 bonds outstanding with a face value of $1,000 and a 6% coupon, one-year maturity.
-There are no taxes, and the risk-free rate is 3%
-F has 1m cash at the beginning of year 1.
-F’s cost of debt is 4% regardless of the payout policy they choose.
F can distribute at the beginning of year 1 either 70% of its cash or 30% of its cash. The cash retained by the firm is invested at the risk-free rate.
Stockholders invest the dividend they receive at the beginning of year 1 at the risk-free rate as well.
Question:
Suppose instead that the market value of the bonds is 2m regardless of the payout policy chosen. The required return on the firm’s assets is 10%, and the required return on equity, if the firm had zero cash, is 12%. Which of the two payout policies will the firm’s shareholders optimally undertake and why?
Consider a firm F that generates a single cash flow in one year which depends on the state of the economy:
-Boom (probability 1/2) 5m -Recession (probability 1/2) 1m
-F has 2,000 bonds outstanding with a face value of $1,000 and a 6% coupon, one-year maturity.
-There are no taxes, and the risk-free rate is 3%
-F has 1m cash at the beginning of year 1.
-F’s cost of debt is 4% regardless of the payout policy they choose.
F can distribute at the beginning of year 1 either 70% of its cash or 30% of its cash. The cash retained by the firm is invested at the risk-free rate.
Stockholders invest the dividend they receive at the beginning of year 1 at the risk-free rate as well.
Question:
Suppose instead that the market value of the bonds is 2m regardless of the payout policy chosen. The required return on the firm’s assets is 10%, and the required return on equity, if the firm had zero cash, is 12%. Which of the two payout policies will the firm’s shareholders optimally undertake and why?
Related questions
Drexel Corp has a target debt ratio (debt/value) of 60%. The 10-year bonds have a coupon rate of 8.3% (paid annually) and currently trade for $1125 per bond. The tax rate is 30%. They have the following information on their stock (You will need to fill in the blanks):
| Current EPS | 8 |
| Current Dividend | 6 |
| Return on Equity | 20% |
| Current Price | $50 |
| Payout Rate = Div/EPS | |
| Growth = Retention x ROE |
a) Calculate the weighted average cost of capital.
b) The firm has a 3-year planning period. The firm expects cash flows of $6M next year, and the cash flows will initially grow at the growth rate. After year 3, they estimate that the cash flows will start to grow at 2% indefinitely. Find the value of the operations.
d) The firm has $8M in cash, $2M in debt and 5M shares outstanding. Find the share price.
Cook Wares has a target debt ratio (debt/value) of 60%. The 10-year bonds have a coupon rate of 8.3% (paid annually) and currently trade for $1125 per bond. The tax rate is 30%. They have the following information on their stock (You will need to fill in the blanks):
| Current EPS | |
| Current Dividend | |
| Return on Equity | |
| Current Price | |
| Payout Rate = Div/EPS | |
| Growth = Retention x ROE |
a) Calculate the weighted average cost of capital.
b) The firm has a 3-year planning period. The firm expects cash flows of $6M next year, and the cash flows will initially grow at the growth rate. After year 3, they estimate that the cash flows will start to grow at 2% indefinitely. Find the value of the operations.
c) The firm has $8M in cash, $2M in debt and 5M shares outstanding. Find the share price.
