QUESTION 1

a. N  4 (2015  2011), PV (initial value)  $2.12, FV (terminal value)  $3.10

Solve for I (growth rate): 9.97%
3. 1
√
4

2. 12
−1=¿ 9.97%
b. Nn  $52 (given in the problem)
c. rr  (Next Dividend  Current Price)  growth rate
rr  ($3.40  $57.50)  0.0997
rr  0.0591  0.0997  0.1588 or 15.88%
d. rr  ($3.40  $52)  0.0997
rr  0.0654  0.0997  0.1651 or 16.51%

QUESTION 2

a.
Debt Ratio 30% 45% 60%
EBIT $2,000,000 $2,000,000 $2,000,000
Less: Interest 270,000 540,000 900,000
EBT 1,730,000 $1,460,000 $1,100,000
 Taxes @40% 692,000 584,000 440,000
Net profit $1,038,000 $ 876,000 $ 660,000
Less: Preferred
 dividends 200,000 200,000 200,000
Profits available to
 common stock $ 838,000 $ 676,000 $ 460,000
No. of shares 140,000 110,000 80,000
outstanding
EPS $ 5.99 $ 6.15 $ 5.75

EPS
P0 
b. rs
Debt: 30% Debt: 45%
$5.99 $6.15
P0   $42.79 P0   $38.44
0.14 0.16
Debt: 60%
$5.75
P0   $28.75
0.20
c. The optimal capital structure would be 30% debt and 70% equity because this is the
debt/equity mix that maximizes the price of the common stock.
QUESTION 3

[100,000  ($2.00  $1.70)] $30,000

DOL R    1.25
a. [100,000  ($2.00  $1.70)]  $6,000 $24,000
$24,000
DFL R   1.71
[$24,000  $10,000]
DTL R  1.25 1.71  2.14
[100,000  ($2.50  $1.00)] $150,000
DOLW    1.71
b. [100,000  ($2.50  $1.00)]  $62,500 $87,500
$87,500
DFLW   1.25
[$87,500  $17,500]
DTL R 1.71  1.25  2.14
c. Firm R has less operating (business) risk but more financial risk than Firm W. The two firms
have differing operating and financial structures but they be equally leveraged. Because total
leverage is the product of operating and financial.

QUESTION 4

a. rs 0.09  0.05  0.14

D1 $3.68
P0  $3.68  (0.14  0.0702)
P0 $52.72
b. (1) rs  0.14
D1  $3.61($3.44  1.0502) 
P0 $3.61  (0.14  0.0502)
P0 $40.20 per share
(2) rs 
D1 $3.68
P0 $3.68  (0.13  0.0702)
P0 $61.54 per share
Price is a function of the current dividend, expected dividend growth rate, the risk-free rate, and
the company-specific risk premium. For Craft, the lowering of the dividend growth rate reduced
future cash flows resulting in a reduction in share price. The decrease in the risk premium
reflected a reduction in risk leading to an increase in share price.