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EPS: Blue Skies Company

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Blue Skies Company has earnings available for common stockholders of $4 million and has 1,000,000 shares of common stock outstanding at $120 per share. The firm is currently contemplating the payment of $4 per share in cash dividends.

a. Calculate the firm's current earnings per share (EPS) and price/earnings (P/E) ratio
b. If the firm can repurchase stock at $124 per share, how many shares can be
purchased in lieu of making the proposed cash dividend payment?
c. How much will the EPS be after the proposed repurchase? Why?
d. If the stock sells at the old P/E ratio, what will the market price be after repurchase?
e.Compare and contrast the earnings per share before and after the proposed repurchase.
f.Compare and contrast the stockholders' position under the dividend and repurchase alternatives

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Comparison of regular cash dividend with a periodic share repurchase

Periodic share repurchase are becoming now more popular because it is increasing the earnings per share post ...

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This solution provides an in-depth set of answers to four questions regarding Blue Skies Company.

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Multiple Choice: Nolan, Selzer, Makeover Inc, Deep River Power, Ski Lifts, Magiclean

1. An analyst has acquired the following information regarding Company A and Company B:

? Company A has a higher net cash flow than Company B.
? Company B has higher net income than Company A.
? Company B has a higher operating cash flow than Company A.
? The companies have the same tax rate, the same level of
capital, and the same cost of capital (WACC).

Assume that non-cash revenues equal zero for both companies, and that depreciation is the only non-cash expense for both companies. Which of the following statements is most correct?

a. Company A has a higher depreciation expense.
b. Company A has a lower level of operating income (EBIT).
c. Company A has a lower EVA.
d. All of the statements above are correct.
e. Only statements a and b are correct.

2. Nolan, Inc. has sales of $1,000,000 and an inventory turnover of 10.0. The firm's current ratio is 3.0, while its quick ratio is 2.5. What are Nolan's current assets?

a. $200,000
b. $300,000
c. $400,000
d. $500,000
e. $600,000

3. Selzer, Inc. sells all its merchandise on credit. It has a profit margin of 4 percent, days sales outstanding equal to 60 days, receivables of $150,000, total assets of $3 million, and a debt ratio of 0.64. What is the firm's return on equity?

a. 7.1%
b. 33.3%
c. 3.3%
d. 71.0%
e. 8.1%

4. When developing pro forma (forecasted) financial statements using the percentage of sales method, which of the following liability accounts generally increase spontaneously with an increase in sales?

a. Accounts payable.
b. Notes payable.
c. Accruals.
d. Statements a and c above.
e. Statements a, b, and c above.

5. Which of the following statements is most correct?

a. The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant capital component which makes up the firm's target capital structure.
b. The weighted average cost of capital is calculated on a before-tax basis.
c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing.
d. Answers a and c are correct.
e. All of the answers above are correct.

6. Which of the following statements is most correct?

a. If Congress cuts the capital gains rate, but leaves the personal tax rate unchanged, then this would provide an incentive for companies to increase their dividend payouts.
b. Despite its drawbacks, a residual dividend policy is an effective way to stabilize dividend payouts, which makes it easier for firms to attract a clientele which prefers high dividends.
c. If a firm follows a residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.
d. All of the statements above are correct.
e. None of the statements above is correct.

7. Makeover Inc. believes that at its current stock price of $16.00 the firm is undervalued in the market. Makeover plans to repurchase 2.4 million of its 20 million shares outstanding. The firm's managers expect that they can repurchase the entire 2.4 million shares at the expected equilibrium price after repurchase. The firm's current earnings are $44 million. If management's assumptions hold, what is the expected market price after repurchase?

a. $16.00
b. $17.26
c. $18.18
d. $20.00
e. $24.40

8. Which of the following statements is most correct?

a. Flotation costs under a best-efforts arrangement are typically less for a given new equity issue than the costs associated with an underwritten offering, and the corporation is more certain of getting the needed funds under a best-efforts offering. This is why best efforts deals are most common.
b. If a firm decides to issue securities through a direct (or private) placement, then the underwriting syndicate that is formed to distribute the securities to the public may, at its discretion, decide either to guarantee or not to guarantee the sale of the securities.
c. If the demand curve for a firm's stock is relatively flat, the firm will have a more difficult time raising a large amount of new equity funds for expansion than would be true if this demand curve were steeper.
d. It is possible for a firm to go public, and yet not raise any additional capital.

9. Deep River Power Corporation recently sold an issue of preferred stock that had an after-tax yield of 9.6 percent. The company's new bonds recently sold at par with an after-tax yield of 8.1 percent. Both issues were placed primarily with corporate investors in the 40 percent tax bracket. Given that the preferred stock enjoys a 70 percent dividend tax exclusion for corporate investors, what was the percentage point difference in the before-tax yields between the two issues?

a. 1.50%
b. 1.20%
c. 2.59%
d. 2.81%
e. 0.21%

10. Which of the following statement completions is most correct? If the yield curve is upward sloping, then a firm's marketable securities portfolio, assumed to be held for liquidity purposes, should be

a. Weighted toward long-term securities because they pay higher rates.
b. Weighted toward short-term securities because they pay higher rates.
c. Weighted toward U.S. Treasury securities to avoid interest rate risk.
d. Weighted toward short-term securities to avoid interest rate risk.
e. Balanced between long- and short-term securities to minimize the effects of either an upward or a downward trend in interest rates.

11. Which of the following statements is most correct?

a. If credit sales as a percentage of a firm's total sales increases, and the volume of credit sales also increases, then the firm's accounts receivable will automatically increase.
b. It is possible for a firm to overstate profits by offering very lenient credit terms which encourage additional sales to financially "weak" firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts.
c. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity.
d. Firms use seasonal dating primarily to decrease their DSO.
e. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st.

12. Ski Lifts Inc. is a highly seasonal business. The following summary balance sheet provides data for peak and off-peak seasons (in thousands of dollars):

Peak Off-peak
Cash $ 50 $ 30
Marketable securities 0 20
Accounts receivable 40 20
Inventories 100 50
Net fixed assets 500 500
$690 $620
liabilities $ 30 $ 10
Short-term debt 50 0
Long-term debt 300 300
Common equity 310 310
$690 $620

From this data we may conclude that

a. Ski Lifts has a working capital financing policy of exactly matching asset and liability maturities.
b. Ski Lifts' working capital financing policy is relatively aggres¬sive; that is, the company finances some of its permanent assets with short-term discretionary debt.
c. Ski Lifts follows a relatively conservative approach to working capital financing; that is, some of its short-term needs are met by permanent capital.
d. Without income statement data, we cannot determine the aggressiveness or conservatism of the company's working capital financing policy.
e. Both statements a and c are correct.

13. Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank?

a. Convenience of location.
b. Competitive cost of services provided.
c. Size of the bank's deposits.
d. Experience of personnel.
e. Loyalty and willingness to assume lending risks.

14. A swap is a method for reducing financial risk. Which of the following statements about swaps, if any, is incorrect?

a. A swap involves the exchange of cash payment obligations.
b. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
c. Swaps are generally arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
d. A problem with swaps is the lack of standardized contracts, which limits the development of a secondary market.
e. All of the statements above are correct.

15. Which of the following statements is most correct?

a. One advantage of forward contracts is that they are default free.
b. Futures contracts generally trade on an organized exchange and are marked to market daily.
c. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
d. Answers a and c are correct.
e. None of the answers above is correct.

16. Magiclean Corporation is considering an acquisition of Dustvac Company. Dustvac has a capital structure consisting of $5 million (market value) in 11% bonds and $10 million (market value) of common stock. Dustvac's pre-merger beta is 1.36. Magiclean's beta is 1.02 and both it and Dustvac face a 40 percent tax rate. Magiclean's capital structure is 40 percent debt and 60 percent equity. The free cash flows from Dustvac are estimated to be $3.0 million for each of the next four years and a horizon value of $10.0 million in Year 4. Tax savings are estimated to be $1 million for each of the next 4 years and a horizon value of $5 million in Year 4. Additionally, new debt would be issued to finance the acquisition and retire the old debt, and this new debt would have an interest rate of 8%. Currently, the risk-free rate is 6.0 percent and the market risk premium is 4.0 percent.

What Dustvac's pre-merger WACC?

a. 9.02%
b. 9.50%
c. 9.83%
d. 10.01%
e. 11.29%

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