ALTERNATIVE DIVIDEND POLICIES Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock outstanding. When CMC’s founder, who was also its research director and most successful inventor, retired unexpectedly to the South Pacific in late 2014, CMC was left suddenly and permanently with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to replace the founder’s contributions to the firm. Previously, CMC found it necessary to reinvest most of its earnings to finance growth, which averaged 12% per year. Future growth at a 6% rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects, with at least the 14% rate of return required by CMC’s stockholders (rs = 14%), would total only $800,000 for 2015, compared to a projected net income of $2,000,000. If the existing 20% dividend payout was continued, retained earnings would be $1 6 million in 2015; but as noted, only $800,000 of investments would yield the 14% cost of capital. The one encouraging point is that the high earnings from existing assets are expected to continue, and net income of $2 million is still expected for 2015. Given the dramatically changed circumstances, CMC’s management is reviewing the firm’s dividend policy.
a. Assuming that the acceptable 2015 investment projects would be financed entirely by earnings retained during the year, and assuming that CMC uses the residual dividend model, calculate DPS in 2015.
b. What payout ratio does your answer to Part a imply for 2015?
c. If a 60% payout ratio is maintained for the foreseeable future, what is your estimate of the present market price for the common stock? How does this compare with the market price that should have prevailed under the assumptions existing just before the news about the founder’s retirement? If the two values of P0 are different, comment
on why they are different.
d. What would happen to the stock price if the old 20% payout was continued? Assume that if this payout is maintained, the average rate of return on the retained earnings will fall to 7 5% and the new growth rate will be as follows: