Problem 1:
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 percent equity and 40 percent 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 the company's dividend per share and payout ratio be for the upcoming year?
c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available to support the capital budget?
d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain a $10 million capital budget without having to raise new common stock?
e. Suppose that Buena Terra's board is firmly opposed to cutting the dividend, that is, insists on maintaining the $3.00 dividend. Also, assume that the company is committed to funding all profitable projects and is willing to issue more debt (along with the available retained earnings) to help finance the capital budget. Assume that the resulting change in capital structure has a minimal impact on the company's composite cost of capital, so that the capital budget remains at $10 million. What % 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. It also wants to maintain its target capital structure (60 percent equity, 40 percent debt) and to finance a $10 million capital budget. What is the minimum dollar amount of new common stock that must be issued to meet these objectives?
g. Now suppose Buena Terra's management wants to maintain the $3.00 DPS and its target capital structure, but it does not want to issue new common stock. Management is willing to cut the capital budget to meet these objectives. Assuming the projects are divisible, what will the company's capital budget be for the next year?
Problem 2: Would each of the following increase, decrease, or have an indeterminant effect on a firm's breakeven point (unit sales)?
a. An increase in the sales price with no change in unit costs.
b. An increase in fixed costs accompanied by a decrease in variable costs.
c. A new firm decides to use MACRS depreciation for both book and tax purposes rather than the straight-line depreciation method.
d. Variable labor costs decline; other things are held constant.