Principles of Finance

Case Solutions
Chapter (1-8)

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CHAPTER 1
THE McGEE CAKE COMPANY
1. The advantages to a LLC are: 1) Reduction of personal liability. A sole proprietor has unlimited
liability, which can include the potential loss of all personal assets. 2) Taxes. Forming an LLC may
mean that more expenses can be considered business expenses and be deducted from the company’s
income. 3) Improved credibility. The business may have increased credibility in the business world
compared to a sole proprietorship. 4) Ability to attract investment. Corporations, even LLCs, can
raise capital through the sale of equity. 5) Continuous life. Sole proprietorships have a limited life,
while corporations have a potentially perpetual life. 6) Transfer of ownership. It is easier to transfer
ownership in a corporation through the sale of stock.

The biggest disadvantage is the potential cost, although the cost of forming a LLC can be relatively
small. There are also other potential costs, including more expansive record-keeping.

2. Forming a corporation has the same advantages as forming a LLC, but the costs are likely to be
higher.

3. As a small company, changing to a LLC is probably the most advantageous decision at the current
time. If the company grows, and Doc and Lyn are willing to sell more equity ownership, the
company can reorganize as a corporation at a later date. Additionally, forming a LLC is likely to be
less expensive than forming a corporation.

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CHAPTER 2
CASH FLOWS AND FINANCIAL
STATEMENTS AT SUNSET BOARDS
Below are the financial statements that you are asked to prepare.

1. The income statement for each year will look like this:

Income statement
2008 2009
Sales $247,259 $301,392
Cost of goods sold 126,038 159,143
Selling & administrative 24,787 32,352
Depreciation 35,581 40,217
EBIT $60,853 $69,680
Interest 7,735 8,866
EBT $53,118 $60,814
Taxes 10,624 12,163
Net income $42,494 $48,651

Dividends $21,247 $24,326

Addition to retained earnings 21,247 24,326

2. The balance sheet for each year will be:

Balance sheet as of Dec. 31, 2008

Cash $18,187 Accounts payable $32,143
Accounts receivable 12,887 Notes payable 14,651
Inventory 27,119 Current liabilities $46,794
Current assets $58,193
Long-term debt $79,235
Net fixed assets $156,975 Owners' equity 89,139
Total assets $215,168 Total liab. & equity $215,168

In the first year, equity is not given. Therefore, we must calculate equity as a plug variable. Since total
liabilities & equity is equal to total assets, equity can be calculated as:

Equity = $215,168 – 46,794 – 79,235

Equity = $89,139

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 Balance sheet as of Dec. 31, 2009
Cash $27,478 Accounts payable $36,404
Accounts receivable 16,717 Notes payable 15,997
Inventory 37,216 Current liabilities $52,401
Current assets $81,411
Long-term debt $91,195
Net fixed assets $191,250 Owners' equity 129,065
Total assets $272,661 Total liab. & equity $272,661

The owner’s equity for 2009 is the beginning of year owner’s equity, plus the addition to retained
earnings, plus the new equity, so:

Equity = $89,139 + 24,326 + 15,600

Equity = $129,065

3. Using the OCF equation:

OCF = EBIT + Depreciation – Taxes

The OCF for each year is:

OCF2008 = $60,853 + 35,581 – 10,624

OCF2008 = $85,180

OCF2009 = $69,680 + 40,217 – 12,163

OCF2009 = $97,734

4. To calculate the cash flow from assets, we need to find the capital spending and change in net
working capital. The capital spending for the year was:

Capital spending
Ending net fixed assets $191,250
– Beginning net fixed assets 156,975
+ Depreciation 40,217
Net capital spending $74,492

And the change in net working capital was:

Change in net working capital

Ending NWC $29,010
– Beginning NWC 11,399
Change in NWC $17,611
 So, the cash flow from assets was:

Cash flow from assets

Operating cash flow $97,734
– Net capital spending 74,492
– Change in NWC 17,611
Cash flow from assets $ 5,631

5. The cash flow to creditors was:

Cash flow to creditors

Interest paid $8,866
– Net new borrowing 11,960
Cash flow to creditors –$3,094

6. The cash flow to stockholders was:

Cash flow to stockholders

Dividends paid $24,326
– Net new equity raised 15,600
Cash flow to stockholders $8,726

Answers to questions

1. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from
operations. The firm invested $17,611 in new net working capital and $74,492 in new fixed assets.
The firm gave $5,631 to its stakeholders. It raised $3,094 from bondholders, and paid $8,726 to
stockholders.

2. The expansion plans may be a little risky. The company does have a positive cash flow, but a large
portion of the operating cash flow is already going to capital spending. The company has had to raise
capital from creditors and stockholders for its current operations. So, the expansion plans may be too
aggressive at this time. On the other hand, companies do need capital to grow. Before investing or
loaning the company money, you would want to know where the current capital spending is going,
and why the company is spending so much in this area already.
CHAPTER 3
RATIOS ANALYSIS AT S&S AIR
1. The calculations for the ratios listed are:

Current ratio = $2,186,520 / $2,919,000

Current ratio = 0.75 times

Quick ratio = ($2,186,250 – 1,037,120) / $2,919,000

Quick ratio = 0.39 times

Cash ratio = $441,000 / $2,919,000

Cash ratio = 0.15 times

Total asset turnover = $30,499,420 / $18,308,920

Total asset turnover = 1.67 times

Inventory turnover = $22,224,580 / $1,037,120

Inventory turnover = 21.43 times

Receivables turnover = $30,499,420 / $708,400

Receivables turnover = 43.05 times

Total debt ratio = ($18,308,920 – 10,069,920) / $18,308,920

Total debt ratio = 0.45 times

Debt-equity ratio = ($2,919,000 + 5,320,000) / $10,069,920

Debt-equity ratio = 0.82 times

Equity multiplier = $18,308,920 / $10,069,920

Equity multiplier = 1.82 times

Times interest earned = $3,040,660 / $478,240

Times interest earned = 6.36 times

Cash coverage = ($3,040,660 + 1,366,680) / $478,420

Cash coverage = 9.22 times

Profit margin = $1,537,452 / $30,499,420

Profit margin = 5.04%

Return on assets = $1,537,452 / $18,308,920

Return on assets = 8.40%

Return on equity = $1,537,452 / $10,069,920

Return on equity = 15.27%

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 CHAPTER 3 C-6

2. Boeing is probably not a good aspirant company. Even though both companies manufacture
airplanes, S&S Air manufactures small airplanes, while Boeing manufactures large, commercial
aircraft. These are two different markets. Additionally, Boeing is heavily involved in the defense
industry, as well as Boeing Capital, which finances airplanes.

Bombardier is a Canadian company that builds business jets, short-range airliners and fire-fighting
amphibious aircraft and also provides defense-related services. It is the third largest commercial
aircraft manufacturer in the world. Embraer is a Brazilian manufacturer than manufactures
commercial, military, and corporate airplanes. Additionally, the Brazilian government is a part
owner of the company. Bombardier and Embraer are probably not good aspirant companies because
of the diverse range of products and manufacture of larger aircraft.

Cirrus is the world's second largest manufacturer of single-engine, piston-powered aircraft. Its
SR22 is the world's best selling plane in its class. The company is noted for its innovative small
aircraft and is a good aspirant company.

Cessna is a well known manufacturer of small airplanes. The company produces business jets,
freight- and passenger-hauling utility Caravans, personal and small-business single engine pistons.
It may be a good aspirant company, however, its products could be considered too broad and
diversified since S&S Air produces only small personal airplanes.

3. S&S is below the median industry ratios for the current and cash ratios. This implies the company
has less liquidity than the industry in general. However, both ratios are above the lower quartile, so
there are companies in the industry with lower liquidity ratios than S&S Air. The company may
have more predictable cash flows, or more access to short-term borrowing. If you created an
Inventory to Current liabilities ratio, S&S Air would have a ratio that is lower than the industry
median. The current ratio is below the industry median, while the quick ratio is above the industry
median. This implies that S&S Air has less inventory to current liabilities than the industry median.
S&S Air has less inventory than the industry median, but more accounts receivable than the
industry since the cash ratio is lower than the industry median.

The turnover ratios are all higher than the industry median; in fact, all three turnover ratios are
above the upper quartile. This may mean that S&S Air is more efficient than the industry.

The financial leverage ratios are all below the industry median, but above the lower quartile. S&S
Air generally has less debt than comparable companies, but still within the normal range.

The profit margin, ROA, and ROE are all slightly below the industry median, however, not
dramatically lower. The company may want to examine its costs structure to determine if costs can
be reduced, or price can be increased.

Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look
may be needed in this area.

Below is a list of possible reasons it may be good or bad that each ratio is higher or lower than the
industry. Note that the list is not exhaustive, but merely one possible explanation for each ratio.
Ratio Good
Current ratio Better at managing current
accounts.
Quick ratio Better at managing current
accounts.
Cash ratio Better at managing current
accounts.
Total asset turnover Better at utilizing assets.
Inventory turnover Better at inventory management,
possibly due to better procedures.
Receivables turnover Better at collecting receivables.
Total debt ratio Less debt than industry median
means the company is less likely
to experience credit problems.
Debt-equity ratio Less debt than industry median
means the company is less likely
to experience credit problems.
Equity multiplier Less debt than industry median
means the company is less likely
to experience credit problems.
TIE Higher quality materials could be
increasing costs.
Cash coverage Less debt than industry median
means the company is less likely
to experience credit problems.
Profit margin The PM is slightly below the
industry median. It could be a
result of higher quality materials
or better manufacturing.
ROA Company may have newer assets
than the industry.
ROE Lower profit margin may be a
result of higher quality.
CHAPTER 3 C-7
Bad
May be having liquidity problems.
May be having liquidity problems.
May be having liquidity problems.
Assets may be older and
depreciated, requiring extensive
investment soon.
Could be experiencing inventory
shortages.
May have credit terms that are too
strict. Decreasing receivables
turnover may increase sales.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
The company may have more
difficulty meeting interest
payments in a downturn.
Increasing the amount of debt can
increase shareholder returns.
Especially notice that it will
increase ROE.
Company may be having trouble
controlling costs.
Company may have newer assets
than the industry.
Profit margin and EM are lower
than industry, which results in the
lower ROE.
CHAPTER 4
PLANNING FOR GROWTH AT S&S AIR
1. To calculate the internal growth rate, we first need to find the ROA and the retention ratio, so:

ROA = NI / TA
ROA = $1,537,452 / $18,309,920
ROA = .0840 or 8.40%

b = Addition to RE / NI
b = $977,452 / $1,537,452
b = 0.64

Now we can use the internal growth rate equation to get:

Internal growth rate = (ROA × b) / [1 – (ROA × b)]

Internal growth rate = [0.0840(.64)] / [1 – 0.0840(.64)]
Internal growth rate = .0564 or 5.64%

To find the sustainable growth rate, we need the ROE, which is:

ROE = NI / TE
ROE = $1,537,452 / $10,069,920
ROE = .1527 or 15.27%

Using the retention ratio we previously calculated, the sustainable growth rate is:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [0.1527(.64)] / [1 – 0.1527(.64)]
Sustainable growth rate = .1075 or 10.75%

The internal growth rate is the growth rate the company can achieve with no outside financing of any
sort. The sustainable growth rate is the growth rate the company can achieve by raising outside debt
based on its retained earnings and current capital structure.

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 CHAPTER 4 C-9

2. Pro forma financial statements for next year at a 12 percent growth rate are:

Income statement
Sales $ 34,159,350
COGS 24,891,530
Other expenses 4,331,600
Depreciation 1,366,680
EBIT $ 3,569,541
Interest 478,240
Taxable income $ 3,091,301
Taxes (40%) 1,236,520
Net income $ 1,854,780

Dividends $ 675,583
Add to RE 1,179,197

Balance sheet
Assets Liabilities & Equity
Current Assets Current Liabilities
Cash $ 493,920 Accounts Payable $ 995,680
Accounts rec. 793,408 Notes Payable 2,030,000
Inventory 1,161,574 Total CL $ 3,025,680
Total CA $ 2,448,902
Long-term debt $ 5,320,000

Shareholder Equity
Common stock $ 350,000
Fixed assets Retained earnings 10,899,117
Net PP&E $ 18,057,088 Total Equity $ 11,249,117

Total Assets $ 20,505,990 Total L&E $ 19,594,787

So, the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $20,505,990 – 19,594,797
EFN = $911,193

The company can grow at this rate by changing the way it operates. For example, if profit margin
increases, say by reducing costs, the ROE increases, it will increase the sustainable growth rate. In
general, as long as the company increases the profit margin, total asset turnover, or equity multiplier,
the higher growth rate is possible. Note however, that changing any one of these will have the effect
of changing the pro forma financial statements.
 CHAPTER 4 C-10

3. Now we are assuming the company can only build in amounts of $5 million. We will assume that the
company will go ahead with the fixed asset acquisition. To estimate the new depreciation charge, we
will find the current depreciation as a percentage of fixed assets, then, apply this percentage to the
new fixed assets. The depreciation as a percentage of assets this year was:

Depreciation percentage = $1,366,680 / $16,122,400

Depreciation percentage = .0848 or 8.48%

The new level of fixed assets with the $5 million purchase will be:

New fixed assets = $16,122,400 + 5,000,000 = $21,122,400

So, the pro forma depreciation will be:

Pro forma depreciation = .0848($21,122,400)

Pro forma depreciation = $1,790,525

We will use this amount in the pro forma income statement. So, the pro forma income statement will
be:

Income statement
Sales $ 34,159,350
COGS 24,891,530
Other expenses 4,331,600
Depreciation 1,790,525
EBIT $ 3,145,696
Interest 478,240
Taxable income $ 2,667,456
Taxes (40%) 1,066,982
Net income $ 1,600,473

Dividends $ 582,955
Add to RE 1,017,519
 CHAPTER 4 C-11

The pro forma balance sheet will remain the same except for the fixed asset and equity accounts. The
fixed asset account will increase by $5 million, rather than the growth rate of sales.

Balance sheet
Assets Liabilities & Equity
Current Assets Current Liabilities
Cash $ 493,920 Accounts Payable $ 995,680
Accounts rec. 793,408 Notes Payable 2,030,000
Inventory 1,161,574 Total CL $ 3,025,680
Total CA $ 2,448,902
Long-term debt $ 5,320,000

Shareholder Equity
Common stock $ 350,000
Fixed assets Retained earnings 10,737,439
Net PP&E $ 21,122,400 Total Equity $ 11,087,439

Total Assets $ 23,571,302 Total L&E $ 19,433,119

So, the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $23,581,302 – 19,433,119
EFN = $4,138,184

Since the fixed assets have increased at a faster percentage than sales, the capacity utilization for
next year will decrease.
CHAPTER 6
THE MBA DECISION
1. Age is obviously an important factor. The younger an individual is, the more time there is for the
(hopefully) increased salary to offset the cost of the decision to return to school for an MBA. The
cost includes both the explicit costs such as tuition, as well as the opportunity cost of the lost salary.

2. Perhaps the most important nonquantifiable factors would be whether or not he is married and if he
has any children. With a spouse and/or children, he may be less inclined to return for an MBA since
his family may be less amenable to the time and money constraints imposed by classes. Other factors
would include his willingness and desire to pursue an MBA, job satisfaction, and how important the
prestige of a job is to him, regardless of the salary.

3. He has three choices: remain at his current job, pursue a Wilton MBA, or pursue a Mt. Perry MBA.
In this analysis, room and board costs are irrelevant since presumably they will be the same whether
he attends college or keeps his current job. We need to find the aftertax value of each, so:

Remain at current job:

Aftertax salary = $55,000(1 – .26) = $40,700

His salary will grow at 3 percent per year, so the present value of his aftertax salary is:

PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

PV = $40,700{[1 – [(1 +.065)/(1 + .03)]38} / (.065 – .03)
PV = $836,227.34

Wilton MBA:

Costs:

Total direct costs = $63,000 + 2,500 + 3,000 = $68,500

PV of direct costs = $68,500 + 68,500 / (1.065) = $132,819.25

PV of indirect costs (lost salary) = $40,700 / (1.065) + $40,700(1 + .03) / (1 + .065)2 = $75,176.00

Salary:

PV of aftertax bonus paid in 2 years = $15,000(1 – .31) / 1.0652 = $9,125.17

Aftertax salary = $98,000(1 – .31) = $67,620

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 CHAPTER 6 C-13

His salary will grow at 4 percent per year. We must also remember that he will now only work for 36
years, so the present value of his aftertax salary is:

PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

PV = $67,620{[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04)
PV = $1,554,663.22

Since the first salary payment will be received three years from today, so we need to discount this for
two years to find the value today, which will be:

PV = $1,544,663.22 / 1.0652
PV = $1,370,683.26

So, the total value of a Wilton MBA is:

Value = –$75,160 – 132,819.25 + 9,125.17 + 1,370,683.26 = $1,171,813.18

Mount Perry MBA:

Costs:

Total direct costs = $78,000 + 3,500 + 3,000 = $86,500. Note, this is also the PV of the direct costs
since they are all paid today.

PV of indirect costs (lost salary) = $40,700 / (1.065) = $38,215.96

Salary:

PV of aftertax bonus paid in 1 year = $10,000(1 – .29) / 1.065 = $6,666.67

Aftertax salary = $81,000(1 – .29) = $57,510

His salary will grow at 3.5 percent per year. We must also remember that he will now only work for
37 years, so the present value of his aftertax salary is:

PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

PV = $57,510{[1 – [(1 +.065)/(1 + .035)]37} / (.065 – .035)
PV = $1,250,991.81

Since the first salary payment will be received two years from today, so we need to discount this for
one year to find the value today, which will be:

PV = $1,250,991.81 / 1.065
PV = $1,174,640.20

So, the total value of a Mount Perry MBA is:

Value = –$86,500 – 38,215.96 + 6,666.67 + 1,174,640.20 = $1,056,590.90

 CHAPTER 6 C-14

4. He is somewhat correct. Calculating the future value of each decision will result in the option with
the highest present value having the highest future value. Thus, a future value analysis will result in
the same decision. However, his statement that a future value analysis is the correct method is wrong
since a present value analysis will give the correct answer as well.

5. To find the salary offer he would need to make the Wilton MBA as financially attractive as the as the
current job, we need to take the PV of his current job, add the costs of attending Wilton, and the PV
of the bonus on an aftertax basis. So, the necessary PV to make the Wilton MBA the same as his
current job will be:

PV = $836,227.34 + 132,819.25 + 75,176.00 – 9,125.17 = $1,035,097.42

This PV will make his current job exactly equal to the Wilton MBA on a financial basis. Since his
salary will still be a growing annuity, the aftertax salary needed is:

PV = C {1 – [(1 + g)/(1 + r)]t} / (r – g)]

$1,035,097.42 = C {[1 – [(1 +.065)/(1 + .04)]36} / (.065 – .04)
C = $45,021.51

This is the aftertax salary. So, the pretax salary must be:

Pretax salary = $45,021.51 / (1 – .31) = $65,248.57

6. The cost (interest rate) of the decision depends on the riskiness of the use of funds, not the source of
the funds. Therefore, whether he can pay cash or must borrow is irrelevant. This is an important
concept which will be discussed further in capital budgeting and the cost of capital in later chapters.
CHAPTER 7
FINANCING S&S AIR’S EXPANSION
PLANS WITH A BOND ISSUE
A rule of thumb with bond provisions is to determine who benefits by the provision. If the company
benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a
lower coupon rate.

1. A bond with collateral will have a lower coupon rate. Bondholders have the claim on the collateral,
even in bankruptcy. Collateral provides an asset that bondholders can claim, which lowers their risk
in default. The downside of collateral is that the company generally cannot sell the asset used as
collateral, and they will generally have to keep the asset in good working order.

2. The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy
proceedings before subordinated bonds receive any payment. A potential problem may arise in that
the bond covenant may restrict the company from issuing any future bonds senior to the current
bonds.

3. A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The
problem with a sinking fund is that the company must make the interim payments into a sinking fund
or face default. This means the company must be able to generate these cash flows.

4. A provision with a specific call date and prices would increase the coupon rate. The call provision
would only be used when it is to the company’s advantage, thus the bondholder’s disadvantage. The
downside is the higher coupon rate. The company benefits by being able to refinance at a lower rate
if interest rates fall significantly, that is, enough to offset the call provision cost.

5. A deferred call would reduce the coupon rate relative to a call provision with a deferred call. The
bond will still have a higher rate relative to a plain vanilla bond. The deferred call means that the
company cannot call the bond for a specified period. This offers the bondholders protection for this
period. The disadvantage of a deferred call is that the company cannot call the bond during the call
protection period. Interest rates could potentially fall to the point where it would be beneficial for the
company to call the bond, yet the company is unable to do so.

6. A make-whole call provision should lower the coupon rate in comparison to a call provision with
specific dates since the make-whole call repays the bondholder the present value of the future cash
flows. However, a make-whole call provision should not affect the coupon rate in comparison to a
plain vanilla bond. Since the bondholders are made whole, they should be indifferent between a plain
vanilla bond and a make-whole bond. If a bond with a make-whole provision is called, bondholders
receive the market value of the bond, which they can reinvest in another bond with similar
characteristics. If we compare this to a bond with a specific call price, investors rarely receive the
full market value of the future cash flows.

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 CHAPTER 7 C-16

7. A positive covenant would reduce the coupon rate. The presence of positive covenants protects
bondholders by forcing the company to undertake actions that benefit bondholders. Examples of
positive covenants would be: the company must maintain audited financial statements; the company
must maintain a minimum specified level of working capital or a minimum specified current ratio;
the company must maintain any collateral in good working order. The negative side of positive
covenants is that the company is restricted in its actions. The positive covenant may force the
company into actions in the future that it would rather not undertake.

8. A negative covenant would reduce the coupon rate. The presence of negative covenants protects
bondholders from actions by the company that would harm the bondholders. Remember, the goal of
a corporation is to maximize shareholder wealth. This says nothing about bondholders. Examples of
negative covenants would be: the company cannot increase dividends, or at least increase beyond a
specified level; the company cannot issue new bonds senior to the current bond issue; the company
cannot sell any collateral. The downside of negative covenants is the restriction of the company’s
actions.

9. Even though the company is not public, a conversion feature would likely lower the coupon rate.
The conversion feature would permit bondholders to benefit if the company does well and also goes
public. The downside is that the company may be selling equity at a discounted price.

10. The downside of a floating-rate coupon is that if interest rates rise, the company has to pay a higher
interest rate. However, if interest rates fall, the company pays a lower interest rate.
 CHAPTER 7 C-17

CHAPTER 8
STOCK VALUATION AT RAGAN, INC.
1. The total dividends paid by the company were $126,000. Since there are 100,000 shares outstanding,
the total earnings for the company were:

Total earnings = 100,000($4.54) = $454,000

This means the payout ratio was:

Payout ratio = $126,000/$454,000 = 0.28

So, the retention ratio was:

Retention ratio = 1 – .28 = 0.72

Using the retention ratio, the company’s growth rate is:

g = ROE × b = .28(.72) = .1806 or 18.06%

The dividend per share paid this year was:

D0 = $63,000 / 50,000
D0 = $1.26

Now we can find the stock price, which is:

P0 = D1 / (R – g)
P0 = $1.26(1.1806) / (.20 – .1806)
P0 = $76.75

2. Since Expert HVAC had a write off which affected its earnings per share, we need to recalculate the
industry EPS. So, the industry EPS is:

Industry EPS = ($0.79 + 1.38 + 1.06) / 3 = $1.08

Using this industry EPS, the industry payout ratio is:

Industry payout ratio = $0.40/$1.08 = .3715 or 37.15%

So, the industry retention ratio is

Industry retention ratio = 1 – .3715 = .6285 or 62.85%

 CHAPTER 7 C-18

This means the industry growth rate is:

Industry g = .1233(.6285) = .0775 or 7.75%

The company will continue to grow at its current pace for five years before slowing to the industry
growth rate. So, the total dividends for each of the next six years will be:

D1 = $1.26(1.1806) = $1.49
D2 = $1.49(1.1806) = $1.76
D3 = $1.76(1.1806) = $2.07
D4 = $2.07(1.1806) = $2.45
D5 = $2.45(1.1806) = $2.89
D6 = $2.89(1.0849) = $3.11

The stock price in Year 5 with the industry required return will be:

Stock value in Year 5 = $3.11 / (.1167 – .0775) = $79.54

This means the total value of the stock today is:

P0 = $1.149/1.1167 + $1.76/1.11672 + $2.07/1.11673 + $2.45/1.11674 + ($2.89 + 79.54) / 1.11675

P0 = $53.28

3. Using the revised industry EPS, the industry PE ratio is:

Industry PE = $13.09 / $1.08 = 12.15

Using the original stock price assumption, Ragan’s PE ratio is:

Ragan PE (original assumptions) = $76.75 / $4.54 = 16.90

Using the revised assumptions, Ragan’s PE = $53.28 / $4.54 = 11.74

Obviously, using the original assumptions, Ragan’s PE is too high. The PE using the revised
assumptions is close to the industry PE ratio. Using the industry average PE, we can calculate a
stock price for Ragan, which is:

Stock price implied by industry PE = 12.15($4.32) = $55.18

4. If the ROE on the company’s projects exceeds the required return, the company should retain
earnings and reinvest. If the ROE on the company’s projects is lower than the required return, the
company should pay dividends. This makes logical sense. Consider a company with a 10 percent
required return. If the company can keep retained earnings and reinvest those earnings at 15 percent,
shareholders would be better off since the dividends in future years would be more than needed for
the required return.
 CHAPTER 7 C-19

5. Again, we will assume the results in Question 2 are correct. The growth rate of the company we
calculated in this question was the industry growth rate of 7.75 percent. Since the growth rate is:

g = ROE × b

If we assume the payout ratio remains constant, the ROE is:

.0775 = ROE(.72)
ROE = .1073 or 10.73%

6. The most obvious solution is to retain more of the company’s earnings and invest in profitable
opportunities. This strategy will not work if the return on the company’s investment is lower than the
required return on the company’s stock.