# Preferred dividends - Expert Answers

P7–2 Preferred dividends Slater Lamp Manufacturing has an outstanding issue of preferred stock with an \$80 par value and an 11% annual dividend.
a. What is the annual dollar dividend? If it is paid quarterly, how much will be paid
each quarter?
b. If the preferred stock is noncumulative and the board of directors has passed the preferred dividend for the last three quarters, how much must be paid to preferred stockholders in the current quarter before dividends are paid to common stockholders?
c. If the preferred stock is cumulative and the board of directors has passed the preferred dividend for the last three quarters, how much must be paid to preferred stockholders in the current quarter before dividends are paid to common stockholders?

P7–8 Common stock value: Constant growth Use the constant-growth model (Gordon growth model) to find the value of each firm shown in the following table.
Firm    /    Dividend expected next year/Dividend growth rate/Required return
A                             \$1.20                                           8%                                       13%
B 4.00                    \$4.00                                           5                                           15
C                              0.65                                     10                                         14
D                              6.00                                      8                                        9
E                              2.25                                              8                                            20

P7–10 Common stock value: Constant growth The common stock of Denis and Denis Research, Inc., trades for \$60 per share. Investors expect the company to pay a \$3.90 dividend next year, and they expect that dividend to grow at a constant rate forever. If investors require a 10% return on this stock, what is the dividend growth rate that they are anticipating?

P7–14 Common stock value: Variable growth Lawrence Industries’ most recent annual dividend was \$1.80 per share (D0 = \$1.80), and the firm’s required return is 11%. Find the market value of Lawrence’s shares when:
a. Dividends are expected to grow at 8% annually for 3 years, followed by a 5%
constant annual growth rate in years 4 to infinity.
b. Dividends are expected to grow at 8% annually for 3 years, followed by a 0%
constant annual growth rate in years 4 to infinity.
c. Dividends are expected to grow at 8% annually for 3 years, followed by a 10%
constant annual growth rate in years 4 to infinity.

P7–17 Using the free cash flow valuation model to price an IPO Assume that you have an opportunity to buy the stock of CoolTech, Inc., an IPO being offered for \$12.50 per share. Although you are very much interested in owning the company, you are concerned about whether it is fairly priced. To determine the value of the shares, you have decided to apply the free cash flow valuation model to the firm’s financial data that you’ve developed from a variety of data sources. The key values you have compiled are summarized in the following table.
Free cash flow
Year (t)              FCFt                                    Other data
2016           \$ 700,000                      Growth rate of FCF, beyond 2019 to infinity 5 2%
2017             800,000                        Weighted average cost of capital 5 8%
2018             950,000                          Market value of all debt 5 \$2,700,000
2019           1,100,000                    Market value of preferred stock 5 \$1,000,000
Number of shares of common stock outstanding 5 1,100,000

P7–19 Valuation with price/earnings multiples For each of the firms shown in the following table, use the data given to estimate its common stock value employing price/earnings (P/E) multiples.
Firm                              Expected EPS                       Price/earnings multiple
A                                            \$3.00                                  6.2
B                                             4.50                                   10.0
C                                            1.80                                     12.6
D                                             2.40                                     8.9
E                                              5.10                                   15.0
P8–9 Rate of return, standard deviation, and coefficient of variation Mike is searching for a stock to include in his current stock portfolio. He is interested in Hi-Tech, Inc.; he has been impressed with the company’s computer products and believes that Hi-Tech is an innovative market player. However, Mike realizes that any time you consider a technology stock, risk is a major concern. The rule he follows is to include only securities with a coefficient of variation of returns below 0.90. Mike has obtained the following price information for the period 2012 through 2015. Hi-Tech stock, being growth-oriented, did not pay any dividends during these 4 years.
Stock price
Year                                       Beginning                                              End
2012                                 \$14.36                                                         \$21.55
2013                                    21.55                                                       64.78
2014                                      64.78                                                      72.38
2015                                    72.38                                                           91.80

P8–14 Portfolio analysis You have been given the expected return data shown in the first table on three assets—F, G, and H—over the period 2016–2019.
Expected return
Year                         Asset F             Asset G                   Asset H
2016                      16%                       17%                              14%
2017                       17                           16                                   15
2018                       18                          15                                     16
2019                        19                           14                                   17
Using these assets, you have isolated the three investment alternatives shown in the following table
Alternative         Investment
1                         100% of asset F
2                        50% of asset F and 50% of asset G
3                        50% of asset F and 50% of asset H

a. Calculate the expected return over the 4-year period for each of the three
alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each of the three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for each of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives do you
recommend? Why?

P8–27 Portfolio return and beta Jamie Peters invested \$100,000 to set up the following
portfolio 1 year ago.
Asset      Cost         Beta at purchase           Yearly income          Value today
A         \$20,000               0.80                           \$1,600                          \$20,000
B           35,000                0.95                           1,400                             36,000
C           30,000                1.50                                  —                            34,500
D          15,000                  1.25                             375                              16,500
a. Calculate the portfolio beta on the basis of the original cost figures.
b. Calculate the percentage return of each asset in the portfolio for the year.
c. Calculate the percentage return of the portfolio on the basis of original cost, using income and gains during the year.
d. At the time Jamie made his investments, investors were estimating that the market return for the coming year would be 10%. The estimate of the risk-free rate of return averaged 4% for the coming year. Calculate an expected rate of return for each stock on the basis of its beta and the expectations of market and risk-free returns.
e. On the basis of the actual results, explain how each stock in the portfolio performed relative to those CAPM-generated expectations of performance. What factors could explain these differences?

P9-5 The cost of debt Gronseth Drywall Systems, Inc., is in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informedthe firm that different maturities will carry different coupon rates and sell at different prices. The firm must choose among several alternatives. In each case, the bonds will have a \$1,000 par value and flotation costs will be \$30 per bond. The company is taxed at a rate of 40%. Calculate the after-tax cost of financing with each of the following alternatives.
Alternative Coupon Rate        Time to Maturity (years)      Premium or Discount
A                        9%                               16                                                     \$250
B                          7                                   5                                                          50
C                          6                                    7                                                   par
D                          5                                   10                                                       - 75

P9–7 Cost of preferred stock Taylor Systems has just issued preferred stock. The stock
has a 12% annual dividend and a \$100 par value and was sold at \$97.50 per share.
In addition, flotation costs of \$2.50 per share must be paid.
a. Calculate the cost of the preferred stock.
b. If the firm sells the preferred stock with a 10% annual dividend and nets \$90.00
after flotation costs, what is its cost?

P9–9 Cost of common stock equity: CAPM J&M Corporation common stock has a beta,
b, of 1.2. The risk-free rate is 6%, and the market return is 11%.
a. Determine the risk premium on J&M common stock.
b. Determine the required return that J&M common stock should provide.
c. Determine J&M’s cost of common stock equity using the CAPM.

P9–10 Cost of common stock equity Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently selling for \$57.50. The firm expects to pay a \$3.40 dividend at the end of the year (2016). The dividends for the past 5 years are shown in the following table.
Year    Dividend
2015     \$3.10
2014      2.92
2013      2.60
2012     2.30
2011        2.12
After underpricing and flotation costs, the firm expects to net \$52 per share on a new issue.
a. Determine the growth rate of dividends from 2011 to 2015.
b. Determine the net proceeds, Nn, that the firm will actually receive.
c. Using the constant-growth valuation model, determine the cost of retained earnings, rr.
d. Using the constant-growth valuation model, determine the cost of new common stock, rn.

P9–17 Calculation of individual costs and WACC Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%.
Debt The firm can sell for \$980 a 10-year, \$1,000-par-value bond paying annual
interest at a 10% coupon rate. A flotation cost of 3% of the par value is required
in addition to the discount of \$20 per bond.
Preferred stock Eight percent (annual dividend) preferred stock having a par
value of \$100 can be sold for \$65. An additional fee of \$2 per share must be paid
to the underwriters.
Common stock The firm’s common stock is currently selling for \$50 per share.
The dividend expected to be paid at the end of the coming year (2016) is \$4. Its
dividend payments, which have been approximately 60% of earnings per share in
each of the past 5 years, were as shown in the following table.

Year    Dividend
2015     \$3.75
2014     3.50
2013     3.30
2012      3.15
2011       2.85

It is expected that to attract buyers, new common stock must be underpriced \$5 per share, and the firm must also pay \$3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings. (Assume that rr = rs.)
a. Calculate the after-tax cost of debt.
b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock.
d. Calculate the WACC for Dillon Labs.

P10–4 Long-term investment decision, payback method Bill Williams has the opportunity to invest in project A that costs \$9,000 today and promises to pay annual end-of year payments of \$2,200, \$2,500, \$2,500, \$2,000, and \$1,800 over the next 5 years. Or, Bill can invest \$9,000 in project B that promises to pay annual end-of-year payments of \$1,500, \$1,500, \$1,500, \$3,500, and \$4,000 over the next 5 years.
a. How long will it take for Bill to recoup his initial investment in project A?
b. How long will it take for Bill to recoup his initial investment in project B?
c. Using the payback period, which project should Bill choose?
d. Do you see any problems with his choice?

P10–10 NPV: Mutually exclusive projects Hook Industries is considering the replacement of one of its old drill presses. Three alternative replacement presses are under consideration. The relevant cash flows associated with each are shown in the following table. The firm’s cost of capital is 15%.
LG 3
LG 2 LG 3
LG 3
Press A                Press B                 Press C
Initial investment (CF0)     \$85,000          \$60,000               \$130,000
Year (t) Cash inflows (CFt)
1                                                  \$18,000                   \$12,000                  \$50,000
2                                                  18,000                     14,000                     30,000
3                                                  18,000                   16,000                      20,000
4                                                  18,000                  18,000                        20,000
5                                                  18,000                   20,000                      20,000
6                                                   18,000                  25,000                           30,000
7                                                  18,000                         —                           40,000
8                                                     18,000                       —                         50,000

a. Calculate the net present value (NPV) of each press.
b. Using NPV, evaluate the acceptability of each press.
c. Rank the presses from best to worst using NPV.
d. Calculate the profitability index (PI) for each press.
e. Rank the presses from best to worst using PI.

P10–11 Long-term investment decision, NPV method Jenny Jenks has researched the financial pros and cons of entering into a 1-year MBA program at her state university. The tuition and books for the master’s program will have an up-front cost of \$50,000. If
she enrolls in an MBA program, Jenny will quit her current job, which pays \$50,000
per year after taxes (for simplicity, treat any lost earnings as part of the up-front
cost). On average, a person with an MBA degree earns an extra \$20,000 per year (after
taxes) over a business career of 40 years. Jenny believes that her opportunity cost
of capital is 6%. Given her estimates, find the net present value (NPV) of entering
this MBA program. Are the benefits of further education worth the associated costs?

P10–15 Internal rate of return Peace of Mind, Inc. (PMI), sells extended warranties for durable consumer goods such as washing machines and refrigerators. When PMI sells an extended warranty, it receives cash up front from the customer, but later PMI must cover any repair costs that arise. An analyst working for PMI is considering a warranty for a new line of big-screen TVs. A consumer who purchases the 2-year warranty will pay PMI \$200. On average, the repair costs that PMI must cover will average \$106 for each of the warranty’s 2 years. If PMI has a cost of capital of 7%, should it offer this warranty for sale?

P10–21 All techniques, conflicting rankings Nicholson Roofing Materials, Inc., is considering two mutually exclusive projects, each with an initial investment of \$150,000.
The company’s board of directors has set a maximum 4-year payback requirement
and has set its cost of capital at 9%. The cash inflows associated with the two projects
are shown in the following table.
Cash inflows (CFt)
Year                         Project A                               Project B
1                             \$45,000                                        \$75,000
2                               45,000                                       60,000
3                          45,000                                             30,000
4                         45,000                                              30,000
5                             45,000                                              30,000
6                          45,000                                                  30,000

a. Calculate the payback period for each project.
b. Calculate the NPV of each project at 0%.
c. Calculate the NPV of each project at 9%.
d. Derive the IRR of each project.
e. Rank the projects by each of the techniques used. Make and justify a recommendation.
f. Go back one more time and calculate the NPV of each project using a cost of
capital of 12%. Does the ranking of the two projects change compared to your