Review Problems – Notes 7

Question 1

The balance sheet for Levy Corp. is shown here in market value terms. There are 14,000 shares of stock outstanding.

Market Value Balance Sheet






Fixed Assets










a) The company has declared a dividend of $1.60 per share. The stock goes ex dividend tomorrow. Ignoring any tax effects, what is the stock selling for today? What will it sell for tomorrow? What will the balance sheet look like after the dividends are paid?

b) Suppose the company has announced it is going to repurchase $22,400 worth of stock. What effect will this transaction have on the equity of the company? How many shares will be outstanding? What will the price per share be after the repurchase? Ignoring tax effects, show how the share repurchase is effectively the same as a cash dividend.

Question 2

Flychucker Corporation is evaluating an extra dividend versus a share repurchase. In either case $6,300 would be spent. Current earnings are $2.60 per share, and the stock currently sells for $51 per share. There are 1,500 shares outstanding. Ignore taxes and other imperfections in answering parts (a) and (b).

a) Evaluate the two alternatives in terms of the effect on the price per share of the stock and shareholder wealth.

b) What will be the effect on the company’s EPS and PE ratio under the two different scenarios?

c) In the real world, which of these actions would you recommend? Why?

Question 3

Divco forecasts sales for the next five years as follows:

Year 1 2 3 4 5

Sales ($mil)100110130170250

Divco expects to earn an operating profit margin of 20% each year. Divco’s tax rate is 40%. Divco currently has a net working capital (NWC) balance of $4.8 million, and it expects to maintain a NWC balance by the end of each year equal to 5% of that year’s sales. Divco currently has net property, plant and equipment (PPE) of $50 million, and it expects that it will need to have net PPE by the end of each year equal to 60% of that year’s sales. Divco’s annual depreciation is equal to 10% of net PPE at the end of the previous year. Divco currently has no debt and no plans to issue any debt.

a) If Divco adopted a policy of paying out all of its free cash flow as a dividend to shareholders each year, how much would it pay in dividends in each of the next five years?

b) Do you see any potential problems with the dividend policy described in (a)? If so, explain what these problems are.

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