is $180 mlio tTLE 3 ket value of the stock re but stable 14-15 Ybor City Tobacco

Question

is $180 mlio tTLE 3 ket value of the stock re but stable 14-15 Ybor City Tobacco Company has for many years enjoyed a moderate but soa growth in sales and earnings. In recent times, however, cigar cosisumption and consequently Ybor's sales have been falling, primarily because of the public greater awareness of the health dangers associated with smokaA further declines in tobacco sales m the future, Ybor's mana/en… tually to move almost entirely out of the tobacco business ane fo a developed, diversified product line in growth-oriented industr The is especially interested in the prospects for pollution-control dsvis becasse in research department has already done much work on the probls of filtering smoke. Right now, the company estimates that an investment of 515 million will be necessary to purchase new facilities and to begin productios of these products, but the investment could earn a return of about 18 percent within a short time The only other available investment opportunity costs $6 million and is expected to return about 10.4 percent growth in sales and earnings. In recent times, however, cigar the public's ntiopating in tobacco sales in the future, Ybor's managit bopes even he company a newly The company is expected to pay a $3.00 dividend on its 3 million outstand ing shares, the same as its dividend last year. The directors could be persoaded to change the dividend if there are good reasons for doing so. Total earnings after taxes for the year are expected to be $14.25 million; the common stock is currently selling for $56.25 per share; the firm's target debulassets ratio is 45 percent, and its marginal tax rate is 40 percent. The costs of various forms of financing are as follows:

Explanation / Answer

Since, there are multiple questions, the first four have been answered.

____________

Part 1)

The payout ratio is calculated as follows:

Payout Ratio = (Dividend Per Share*Common Stock Outstanding)/Profit after Taxes = (3*3,000,000)/14,250,000 = 63.16%

_______

With Dividend of $3 Per Share

The break even point is calculated as follows:

Retained Earnings = Total Earnings - Dividends = 14.25 - (3*3) = $5.25 million

Break Even PointRE = Retained Earnings/(1-Debt Ratio) = 5.25/(1-.45) = $9,55 million

______

MCC upto 9.55 million

The formula for calculating MCC is given below:

MCC = After-Tax Cost of Debt*Weight of Debt + Cost of Retained Earnings*Weight of Retained Earnings

Using the information provided in the question, we get,

MCC = 11%*(1-40%)*.45 + 14%*.55 = 10.67%

______

MCC above 9.55 million

The formula for calculating MCC is given below:

MCC = After-Tax Cost of Debt*Weight of Debt + Cost of Retained Earnings*Weight of Retained Earnings

We will have to calculate the growth rate to determine the cost of retained earnings.

Growth Rate = Required Return - D1/Current Stock Price = 14% - 3/56.25 = 8.67%

Cost of Retained Earnings = 3/51.25 + 8.67% = 14.52%

MCC = 11%*(1-40%)*.45 + 14.52%*.55 = 10.96%

_____________

With No Dividend

The break even point is calculated as follows:

Retained Earnings = Total Earnings = 14.25 million

Break Even PointRE = Retained Earnings/(1-Debt Ratio) = 14.25/(1-.45) = 25.91 million

Amount Required to be Borrowed = Break Even Point - Retained Earnings = 25.91 - 14.25 = $11.66 million

MCC upto approximately $25.91 Million = 10.67% (as calculated above)

MCC above approximately $25.91 Million = 10.96% (as calculated above)

________

Part 2)

Ybor’s capital budget will be $15 million. It is so because the growth project’s return is greater than the marginal cost of capital.

________

Part 3)

Investment in new project will require more funds that will have to be generated with the use of internal debt and equity (in the form of retained earnings). In such a case, the only option available with the the management is to reduce its payout ratio from the current level. This can be achieved by reducing the value of current dividend with an increase in the earnings. The payment dividend shouldn't be completely cut down. The company should inform the stockholders that the reduction in dividend payout ratio is on account of investment of earnings in new projects.

With $3 dividend, the financing would be done in the following manner:

New Equity Required = Total Capital Budget - Debt = 15,000,000 - .45*15,000,000 = $8,250,000

Retained Earnings = $5,250,000 (as calculated in Part 1)

New Stock = 8,250,000 - 5,250,000 = $3,000,000

________

Part 4)

New projects are generally presumed to carry above average risks as compared to the existing projects. As investors assume greater risk, they will expect higher returns on their investments. The borrowing from external market may appear to be difficult as the company is already highly leveraged. In such a case, the cost of capital for the company would increase. Additionally, it may not be possible for the company to retain its current debt ratio. Higher risk would result in investors focussing more on cash dividend (to reduce their risks) which in turn will cause the company to increase its dividend payout ratio.

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