Components Manufacturing Corporation (CMC) hasan all-common-equity capital structure. It has 200,000 shares of $2 par value common stockoutstanding. When CMC’s founder, who was also its research director and most successfulinventor, retired unexpectedly to the South Pacific in late 2018, CMC was left suddenly and permanentlywith materially lower growth expectations and relatively few attractive new investmentopportunities. Unfortunately, there was no way to replace the founder’s contributions tothe firm. Previously, CMC found it necessary to reinvest most of its earnings to finance growth,which averaged 12% per year. Future growth at a 6% rate is considered realistic, but that levelwould call for an increase in the dividend payout. Further, it now appears that new investmentprojects, with at least the 14% rate of return required by CMC’s stockholders (rs 5 14%), wouldtotal only $800,000 for 2019, compared to a projected net income of $2,000,000. If the existing20% dividend payout was continued, retained earnings would be $1.6 million in 2019, but asnoted, only $800,000 of investments would yield the 14% cost of capital.The one encouraging point is that the high earnings from existing assets are expectedto continue, and net income of $2 million is still expected for 2019. Given the dramaticallychanged circumstances, CMC’s management is reviewing the firm’s dividend policy.a. Assuming that the acceptable 2019 investment projects would be financed entirely byearnings retained during the year, and assuming that CMC uses the residual dividendmodel, calculate DPS in 2019.b. What payout ratio does your answer to part a imply for 2019?c. If a 60% payout ratio is maintained for the foreseeable future, what is your estimateof the present market price for the common stock? How does this compare with the news about the founder’s retirement? If the two values of P0 are different, comment onwhy they are different.d. What would happen to the stock price if the old 20% payout was continued? Assumethat if this payout is maintained, the average rate of return on the retained earningswill fall to 7.5% and the new growth rate will be as follows:g = (1.0 - Payout ratio)(ROE)=(1.0 - 0.2)(7.5%)= (0.8)(7.5%) = 6.0%
Components Manufacturing Corporation (CMC) has
an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock
outstanding. When CMC’s founder, who was also its research director and most successful
inventor, retired unexpectedly to the South Pacific in late 2018, CMC was left suddenly and permanently
with materially lower growth expectations and relatively few attractive new investment
opportunities. Unfortunately, there was no way to replace the founder’s contributions to
the firm. Previously, CMC found it necessary to reinvest most of its earnings to finance growth,
which averaged 12% per year. Future growth at a 6% rate is considered realistic, but that level
would call for an increase in the dividend payout. Further, it now appears that new investment
projects, with at least the 14%
total only $800,000 for 2019, compared to a projected net income of $2,000,000. If the existing
20% dividend payout was continued,
noted, only $800,000 of investments would yield the 14% cost of capital.
The one encouraging point is that the high earnings from existing assets are expected
to continue, and net income of $2 million is still expected for 2019. Given the dramatically
changed circumstances, CMC’s management is reviewing the firm’s dividend policy.
a. Assuming that the acceptable 2019 investment projects would be financed entirely by
earnings retained during the year, and assuming that CMC uses the residual dividend
model, calculate DPS in 2019.
b. What payout ratio does your answer to part a imply for 2019?
c. If a 60% payout ratio is maintained for the foreseeable future, what is your estimate
of the present market price for the common stock? How does this compare with the news about the founder’s retirement? If the two values of P0 are different, comment on
why they are different.
d. What would happen to the stock price if the old 20% payout was continued? Assume
that if this payout is maintained, the average rate of return on the retained earnings
will fall to 7.5% and the new growth rate will be as follows:
g = (1.0 - Payout ratio)(
=(1.0 - 0.2)(7.5%)
= (0.8)(7.5%) = 6.0%
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