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    Business Example Problems

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    Problem #1
    Your younger sister, Linda, will start college in five years. She has just informed your parents that she wants to go to Hampton University, which will cost $17,000 per year for four years (cost assumed to come at the end of each year). Anticipating Linda's ambitions, your parents started investing $2,000 per year five years ago and will continue to do so for five more years. How much more will your parents have to invest each year for the next five years to have the necessary funds for Linda's education? Use 10 percent as the appropriate interest rate throughout this problem (for discounting or compounding).

    Problem #2
    Lyle Communications had finally arrived at the point where it had sufficient excess cash flow of $2.4 million to consider paying a dividend. It had 2 million shares outstanding and was considering paying a cash dividend of $1.20 per share. The firm's total earnings were $8 million providing $4.00 in earnings per share. Lyle Communications stock traded in the market at $64.00 per share.
    However, Liz Crocker, the chief financial officer, was not sure paying the cash dividend was the best route to go. She had recently read a number of articles in The Wall Street Journal about the advantages of stock repurchases and before she made a recommendation to the CEO and board of directors, she decided to do a number of calculations.
    a. What is the firm's P/E ratio?
    b. If the firm paid the cash dividend, what would be the firm's dividend yield and dividend payout ratio per share?
    c. If a stockholder held 100 shares of stock and received the cash dividend, what would be the total value of his portfolio? (stock plus dividends)
    d. Assume instead of paying the cash dividend, the firm used the $2.4 million of excess funds to purchase shares at slightly over the current market value of $64 at a price of $65.20. How many shares could be repurchased? (round to the nearest share)
    e. What would the new earnings per share be under the stock repurchase alternative? (round to three places to the right of the decimal point)
    f. If the P/E ratio stayed the same under the stock repurchase alternative, what would be the stock value per share? If a stockholder owned 100 shares, what would now be the total value of his portfolio? (This answer should be approximately the same as answer c)

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    Solution Preview

    Problem 1
    The present value of the funds needed for Linda to go to Hampton University is equal to:
    $17,000/(1.10^6) + $17,000/(1.10^7) + $17,000/(1.10^8) + $17,000/(1.10^9) = $33,460
    The first $17,000 is due six years from now since she will start college in five years and the cost is assumed to come at the end of the year (thus six years from now).

    The present value of the $2,000 investments over the past five years is equal to:
    $2,000 * (1.10^5) + $2,000 * (1.10^4) + $2,000 * ...

    Solution Summary

    This solution looks at business example problems: saving for college and stock buy-back. This includes an application of discount rates, P/E ratios, and dividends