Question

1. Rack city , a retail firm, is making a decision on how much it should payout to its shareholders. It has $100 million in investable funds. The firm has 100 million shares outstanding, selling for $15 per share. The beta of the stock is 1.25 and the risk-free rate is 8%. The expected return on the market is 16%. Currently the firm has $500 million of debt outstanding, with a marginal yield of 12%. The corporate tax rate is 50%. Assume the firm will finance any investments at its current debt ratio and has the following projects available:

   Project	Investment ($ millions)	After-tax return on capital (%)
   A	15	27
   B	10	20
   C	25	16
   D	20	14
   E	30	12

   1. Based on this information, what is the company’s projected capital expenditure next year (i.e. which of the five projects would you accept and why)?
   2. Assuming the firm accepts your investment recommendation, what is the maximum amount that the company will have available to pay out as dividends next year?
   3. Would you pay out this maximum amount as dividends? Why or why not?

Answer 1

Step 1: Find Cost of equity

Cost of equity under CAPM formula = RF+Beta* (RM-RF)

where RF = risk free rrate = 8%

Beta = 1.25

RM = Market rate = 16%

Cost of equity = 8%+(1.25*(16%-8%)) = 8%+10% = 18%

Step 2: Find weighted average cost of capital

Cost of equity = 18%

Equity value = 100 million shares * $15 per share = $1500 million

Cost of Debt = 12% (given in question as yield)

After tax cost of debt = 12% * (1-50%) = 6% (where 50% is the corporate tax rate)

Debt value = $500 million

Equity + Debt value = $2,000 million ($1,500 million+$500 million)

Weighted average cost of capital = Cost of Equity * (Equity value/Equity + Debt Value) + Cost of Debt* (Debt value/Equity + Debt Value)

Weighted average cost of capital = 18%*($1500 million/$2000 million)+6%*($500 million/$2000 million)

= 13.5%+1.5% = 15%

Step 3 : Find the investment to be made

Investable funds available = $100 Million

The following investment opportunities are available:

Project	Investment ($ Million)	After tax return on capital (%)
A	15	27
B	10	20
C	25	16
D	20	14
E	30	12

The cost of capital of the company is 15% which becomes its minium required return on an investment. Hence out of the investment opportunities available, only those whose return on capital is higher than 15% will be selected.

Thus, Projects A , B & C with after tax return on capital of 27%, 20% and 16% respectively will be selected since the return is higher than 15% cost of capital. Projects D & E with after tax return on capital of 14% and 12% respectively will not be selected since the return is lower than 15% cost of capital.

a. Thus, the company’s projected capital expenditure next year = Capital expenditure of Projects A, B & C = $15 Millon + $10 Millon + $25 Millon = $50 Million

b. Out of the investable funds of $100 Million, $50 Million will be invested in Projects A, B & C as above. Hence the balance of $50 Million ($100 Million-$50 Million) is the maximum amount available for the company to pay out as dividend next year.

c. Would you pay out this maximum amount as dividends? Why or why not?

The maximum funds available after investments is $50 Million.

The question is silent on few key aspects including if the company has retained earnings other than these investable funds, the dividend paying history of the company and the capital appreciation in equity value per share. In the absence of these information and assuming that the company hasn't declared dividend in the current year, I would suggest the company not to declare dividend with these maximum available funds for the following reasons:

1. Company has 100 million shares outstanding and with $50 Million distributed as dividend, dividend per share will be $0.50. If the company is valued using the dividend discount model, the price per share will reduce to $2.78 or $3 per share (dividend per share of $0.50/required rate of 18%). This will not help in the capital appreciation of the investors.

2. The company should look out for other investment opportunities for the balance $50 million with the require return being higher than 15%. This will help the company in increasing the return in the form of dividend as well as share value appreciation.