Economics of Enterprise Answers

2. Which of the following statements is CORRECT?

a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt.
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt.

1. Which of the following statements best describes the optimal capital structure?

a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity.
d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt.
e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of preferred stock.

5. DeAngelo Corp.'s projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. DeAngelo has more positive NPV projects than it can finance without issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable future. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.
Increase in Capital Budget
Increase Debt Lower Payout Do Both to 75% to 20%___________________
a. $114.0 $73.3 $333.9
b. $120.0 $77.2 $351.5
c. $126.4 $81.2 $370.0
d. $133.0 $85.5 $389.5
e. $140.0 $90.0 $410.0

4. Which of the following statements is CORRECT?

a. If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm’s dividend payout.
b. The clientele effect can explain why so many firms change their dividend policies so often.
c. One advantage of adopting the residual dividend policy is that this policy makes it easier for corporations to develop a specific and well-identified dividend clientele.
d. New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don’t change the firm’s total amount of book equity.
e. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received.

3. Which of the following statements is CORRECT?

a. When firms are deciding on the size of stock splits—say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used.
b. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today.
c. Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits.
d. When a company declares a stock split, the price of the stock typically declines—by about 50% after a 2-for-1 split—and this necessarily reduces the total market value of the equity.
e. If a firm’s stock price is quite high relative to most stocks

2. Which of the following statements is CORRECT?

a. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company.
b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account.
c. Stock repurchases can be used by a firm that wants to increase its debt ratio.
d. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities.
e. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.

1. Which of the following statements about dividend policies is CORRECT?

a. Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the ―bird-in-the hand‖ effect.
b. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases.
c. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest.
d. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy.
e. The clientele effect suggests that companies should follow a stable dividend policy.

. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions.
Last year’s sales = S0 $300.0 Last year’s accounts payable $50.0
Sales growth rate = g 40% Last year’s notes payable $15.0
Last year’s total assets = A0* $500.0 Last year’s accruals $20.0
Last year’s profit margin = PM 20.0% Initial payout ratio 10.0%

Use the Internet to research an instance where a significant dispute has arisen based on a corporate valuation.
Determine what additional steps can be taken in the valuation of a corporation to avoid instances like the one you researched from occurring in the future. Provide specific examples to support your response.

Analyze the process of forecasting financial statements and make at least one recommendation for improving the accuracy of forecasts. Provide specific examples to support your response.