Buena Terra Corporation - Residual Distribution Model

Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several years, and its share holders expect the dividend to remain constant for the next several years. The company's target capital structure is 60% equity 40% debt it has 1,000,000 hares of common equity outstanding; and its net income is $8 millions. The company forecast that it would require $10 millions to fund all of its profitable (that is, positive NPV) projects for the upcoming year.

A- If Buena Terra follows the residual model and makes all distributions as dividends, how much retained earnings will it need to fund its capital budget?
B- If Buena Terra follows the residual model with all distributions in the form of dividends, what will be the company's dividend per share and payout ratio for the upcoming year?
C- If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available for the firm's capital budget?
D- Can the company maintain its current capital structure, maintain the #3.00 DPS, and maintain a $10 millions capital budget without having to raise new common stock?
E- Suppose that Buena Terra's management is firmly opposed to cutting the divided; for the next year. Also assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the company's budget. Assume that the resulting change in capital structure has a minimal impact on the company's composite cost of capital, so that the capital budget remains a $10 millions. What portion of this year's capital budget would have to be financed with debt?
F- Suppose once again that Buena Terra's management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its target capital structure (60% equity, 40% debt), and maintain its $10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue in order to meet each of its objectives?
G- Now consider the case where Buena Terra's management wants to maintain the $3.00 DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming that the company's are divisible what will be the company's capital budget for the next year?
H- What actions can a firm that follows the residual distributions policy take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?

Problem 21-5 (Convertible Bond Analysis)

Fifteen years ago, Roop Industries sold $400 millions of convertible bonds. The bonds had a 40 year maturity, a 5.75 % coupon rate, and paid interest annually. They were sold at their $1,000 par value. The conversion price was set at $62.75; the common stock price was $55 per share. The bonds were subordinated debentures, and they were given an A rating; straight nonconvertible debentures of the same qualify yielded about 8.75% at the time Roop's bonds were issued.

a- Calculate the premium on the bonds, that is, the percentage excess of the conversion price over the stock price.
b- What Roopo's annual before tax interest savings on the convertible issue versus a straight debt issue?
c- At the time the bonds wee issued, what was the value per bond of the conversion feature?
d- Suppose the price of Roop's common stock fell from $55 on the day the bonds were issued to $32.75 now, 15 years after the issue date (also assume that the stock price never exceeded $62.75). Assume interest rates remained constant.
What is the current price of the straight bond portion of the convertible bond?
What is the current value if a bondholder converts a bond? Do you think it is likely that the bonds will be converted?

e- The bonds originally sold for $1,00. If interest rates on A- rated bonds had remained constant at 8.75% and the stock price had fallen to $32.75, what do you think would have happened to the price of the convertible bonds?
(Assume no change in the standard deviation of stock return).

f- Now suppose the price of Roop's common stock had fallen from $55 on the day the bonds were issued to $32.75 at present, 15 years after the issue. Suppose also tha the rate of interest had fallen form 8.75% to 5.75%. Under these conditions, wha is the current price value if a bondholder converts a bond?
What do you think would have happened to the price of the bonds?

Discusion question:

1-You are a CFO preparing to consider an introduction of a dividend payout policy. What factors would affect your judgment?