Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The company’s target capital structure is 60% equity and 40% debt, it has 1,000,000 shares of common equity outstanding, and its net income is$8 million. The company forecasts that it will require $10 million to fund all of its profitable (i.e., positive NPV) projects for the upcoming year. a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget? b. If Buena Terra follows the residual dividend model, what will be the company’s dividend per share and payout ratio for the upcoming year? c. If Buena Terra maintains its current$3.00 DPS for next year, how much retained earnings will be available for the firm’s capital budget? d. Can the company maintain its current capital structure, the $3.00 DPS, and a$10 million capital budget without having to raise new common stock? e. Suppose that Buena Terra’s management is firmly opposed to cutting the dividend; that is, it wants to maintain the $3.00 dividend for the next year. Also, assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the company’s capital budget. Assume that the resulting change in capital structure has a minimal effect on the company’s composite cost of capital so that the capital budget remains at$10 million. What portion of this year’s capital budget would have to be financed with debt? f. Suppose once again that Buena Terra’s management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its target capital structure (60% equity and 40% debt) and its$10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue to meet each of its objectives? g. Now consider the case where Buena Terra’s management wants to maintain the $3.00 DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget to meet its other objectives. Assuming that the company’s projects are divisible, what will be the company’s capital budget for the next year? h. What actions can a firm that follows the residual dividend model take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?

Your division is considering two projects with the following cash flows (in millions):

$$\begin{matrix} \text{ } & \text{0} & \text{1} & \text{2} & \text{3}\\ \text{Project A} & \text{-\$ 25} & \text{\$ 5} & \text{\$ 10} & \text{\$ 17}\\ \text{Project B} & \text{-\$ 20} & \text{\$ 10} & \text{\$ 9} & \text{\$ 6}\\ \end{matrix}$$

a. What are the projects’ NPVs assuming the WACC is 5%? 10%? 15%? b. What are the projects’ IRRs at each of these WACCs?	c. If the WACC was 5% and A and B were mutually exclusive, which project would you

A bond has a $1,000 par value, 12 years to maturity, and an 8% annual coupon and sells for$980. a. What is its yield to maturity (YTM)? b. Assume that the yield to maturity remains constant for the next three years. What will the price be 3 years from today?

On January 1, 2015, Glover Corporation issued $2,400,000 of 5-year, 8% bonds at 95. The bonds pay interest annually on January 1. By January 1, 2017, the market rate of interest for bonds of risk similar to those of Glover Corporation had risen. As a result, the market value of these bonds was$2,000,000 on January 1, 2017—below their carrying value. Joanna Glover, president of the company, suggests repurchasing all of these bonds in the open market at the $2,000,000 price. To do so, the company will have to issue$2,000,000 (face value) of new 10-year, 11% bonds at par. The president asks you, as controller, “What is the feasibility of my proposed repurchase plan?”

Instructions With the class divided into groups, answer the following. (a) What is the carrying value of the outstanding Glover Corporation 5-year bonds on January 1, 2017? (Assume straight-line amortization.)

Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a 3.00 dollars dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The company's target capital structure is 60 percent equity and 40 percent debt, it has 1,000,000 shares of common equity outstanding, and its net income is 8 million dollars. The company forecasts that it will require 10 million dollars to fund all of its profitable (i.e., positive NPV) projects for the upcoming year.

a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?

b. If Buena Terra follows the residual dividend model, what will be the company's dividend per share and payout ratio for the upcoming year?

c. If Buena Terra maintains its current 3.00 dollars DPS for next year, how much retained earnings will be available for the firm's capital budget?

d. Can the company maintain its current capital structure, the 3.00 dollars DPS, and a 10 million dollars capital budget without having to raise new common stock?

e. Suppose that Buena Terra's management is firmly opposed to cutting the dividend; that is, it wants to maintain the 3.00 dollars dividend for the next year. Also, assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the company's capital budget. Assume that the resulting change in capital structure has a minimal effect on the company's composite cost of capital so that the capital budget remains at 10 million dollars. What portion of this year's capital budget would have to be financed with debt?

f. Suppose once again that Buena Terra's management wants to maintain the 3.00 dollars DPS. In addition, the company wants to maintain its target capital structure (60 percent equity and 40 percent debt) and its 10 million dollars capital budget. What is the minimum dollar amount of new common stock that the company would have to issue to meet each of its objectives?

g. Now consider the case where Buena Terra's management wants to maintain the 3.00 dollars DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget to meet its other objectives. Assuming that the company's projects are divisible, what will be the company's capital budget for the next year?

h. What actions can a firm that follows the residual dividend model take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?

If a triangle has side lengths of 2x, 3x, and 4x, is it an acute, obtuse, or a right triangle?

Pasha Corporation produces motorcycle batteries. Pasha turns out 1,400 batteries a day at a cost of $7 per battery for materials and labor. It takes the firm 22 days to convert raw materials into a battery. Pasha allows its customers 40 days in which to pay for the batteries, and the firm generally pays its suppliers in 30 days. a. What is the length of Pasha’s cash conversion cycle? b. At a steady state in which Pasha produces 1,400 batteries a day, what amount of working capital must it finance? c. By what amount could Pasha reduce its working capital financing needs if it was able to stretch its payables deferral period to 33 days? d. Pasha’s management is trying to analyze the effect of a proposed new production process on its working capital investment. The new production process would allow Pasha to decrease its inventory conversion period to 17 days and to increase its daily production to 2,400 batteries. However, the new process would cause the cost of materials and labor to increase to$12. Assuming the change does not affect the average collection period (40 days) or the payables deferral period (30 days), what will be the length of its cash conversion cycle and its working capital financing requirement if the new production process is implemented?

On January 1, 2012, Kenard Corporation issued $3,000,000, 5-year, 8% bonds at 97. The bonds pay interest annually on January 1. By January 1, 2014, the market rate of interest for bonds of risk similar to those of Kenard Corporation had risen. As a result, the market price of these bonds was$2,500,000 on January 1, 2014—below their carrying value of $2,946,000.

Mel Garner, president of the company, suggests repurchasing all of these bonds in the open market at the$2,500,000 price. But to do so the company will have to issue $2,500,000 (face value) of new 10-year, 12% bonds at par. The president asks you, as controller, “What is the feasibility of my proposed repurchase plan?”

Instructions

With the class divided into groups, answer the following.

(a) Prepare the journal entry to redeem the 5-year bonds on January 1, 2014. Prepare the journal entry to issue the new 10-year bonds.

Your division is considering two projects. Its WACC is 10%, and the projects’ after-tax cash flows (in millions of dollars) would be as follows:

$$\begin{matrix} \text{ } & \text{0} & \text{1} & \text{2} & \text{3} & \text{4}\\ \text{Project A} & \text{- \$ 30} & \text{\$ 5} & \text{\$ 10} & \text{\$ 15} & \text{\$ 20}\\ \text{Project B} & \text{- \$ 30} & \text{\$ 20} & \text{\$ 10} & \text{\$ 8} & \text{\$ 6}\\ \end{matrix}$$

a. Calculate the projects’ NPVs, IRRs, MIRRs, regular paybacks, and discounted paybacks. b. If the two projects are independent, which project(s) should be chosen? c. If the two projects are mutually exclusive and the WACC is 10%, which project(s) should be chosen? d. Plot NPV profiles for the two projects. Identify the projects’ IRRs on the graph. e. If the WACC was 5%, would this change your recommendation if the projects were mutually exclusive? If the WACC was 15%, would this change your recommendation? Explain your answers. f. The crossover rate is 13.5252%. Explain what this rate is and how it affects the choice between mutually exclusive projects. g. Is it possible for conflicts to exist between the NPV and the IRR when independent projects are being evaluated? Explain your answer. h. Now look at the regular and discounted paybacks. Which project looks better when judged by the paybacks? i. If the payback was the only method a firm used to accept or reject projects, what payback should it choose as the cutoff point, that is, reject projects if their paybacks are not below the chosen cutoff? Is your selected cutoff based on some economic criteria, or is it more or less arbitrary? Are the cutoff criteria equally arbitrary when firms use the NPV and/or the IRR as the criteria? Explain. j. Define the MIRR. What’s the difference between the IRR and the MIRR, and which generally gives a better idea of the rate of return on the investment in a project? Explain. k. Why do most academics and financial executives regard the NPV as being the single best criterion and better than the IRR? Why do companies still calculate IRRs?

Walsh Company is considering three independent projects, each of which requires a $4 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here:$ $$ \begin{matrix} \text{Project H (high risk):} & \text{Cost of capital =16\\%} & \text{IRR=19\\%}\\ \text{Project M (medium risk):} & \text{Cost of capital =12\\%} & \text{IRR=13\\%}\\ \text{Project L(low risk):} & \text{Cost of capital =9\\%} & \text{IRR=8\\%}\\ \end{matrix} $$ $Note that the projects’ costs of capital vary because the projects have different levels of risk. The company’s optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of$7,500,000. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio?

Coastal Carolina Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 45% with a $20 million investment in plant and machinery. The firm wants to maintain a 35% debt level in its capital structure. It also wants to maintain its past dividend policy of distributing 55% of last year’s net income. In 2016, net income was$5 million. How much external equity must Coastal Carolina seek at the beginning of 2017 to expand capacity as desired? Assume that the firm uses only debt and common equity in its capital structure.

In 2015, Keenan Company paid dividends totaling $3,600,000 on net income of$10.8 million. Note that 2015 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2016, earnings are expected to jump to $14.4 million and the firm expects to have profitable investment opportunities of$8.4 million. It is predicted that Keenan will not be able to maintain the 2016 level of earnings growth because the high 2016 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2016, the company will return to its previous 10% growth rate. Keenan’s target capital structure is 40% debt and 60% equity.

a. Calculate Keenan’s total dividends for 2016 assuming that it follows each of the following policies:

1. Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.

2. It continues the 2015 dividend payout ratio.

3. It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt and 60% with common equity).

4. It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual dividend policy.

b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer.

c. Assume that investors expect Keenan to pay total dividends of$9,000,000 in 2016 and to have the dividend grow at 10% after 2016. The stock’s total market value is $180 million. What is the company’s cost of equity?

d. What is Keenan’s long-run average return on equity? [Hint: g=Retention rate$\times$ROE=(1.0-Payout rate)(ROE)]

e. Does a 2016 dividend of$9,000,000 seem reasonable in view of your answers to parts c

Assume you observe the following situation:

Security	Beta	Expected Return
Pete Corp.	1.21	.1079
Repete Corp.	.83	.0843

Suppose these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk-free rate?

In 2015, Keenan Company paid dividends totaling $3,600,000 on net income of$10.8 million. Note that 2015 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2016, earnings are expected to jump to $14.4 million and the firm expects to have profitable investment opportunities of$8.4 million. It is predicted that Keenan will not be able to maintain the 2016 level of earnings growth because the high 2016 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2016, the company will return to its previous 10% growth rate. Keenan’s target capital structure is 40% debt and 60% equity.

a. Calculate Keenan’s total dividends for 2016 assuming that it follows each of the following policies:

1. Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.

2. It continues the 2015 dividend payout ratio.

3. It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt and 60% with common equity).

4. It employs a regular dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual dividend policy.

b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer.

c. Assume that investors expect Keenan to pay total dividends of$9,000,000 in 2016 and to have the dividend grow at 10% after 2016. The stock’s total market value is $180 million. What is the company’s cost of equity?

d. What is Keenan’s long-run average return on equity?

[Hint: g=Retention rate$\times$ROE=(1.0-Payout rate)(ROE)]

e. Does a 2016 dividend of$9,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower? Explain your answer.