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Finance - target capital structure

1. Fidelity company has a target capital structure that consists of 40 percent debt and 60 percent equity. The company's capital budget for next year is $10 million. Axel expects net income of $8 million. The company's cost of capital is 12 percent.

a. How much will the company pay out in dividends if it follows a residual dividend policy?
b. What is the company's dividend payout ratio if it pays the dividends calculated above?
c. Is it likely the company will follow a residual dividend policy? Why or why not?

d. If the company decided to pay out $4.5 million in dividends, how much would it need to raise in equity outside the company?

e. Should the company go ahead with a project of average risk that generates a 10 percent rate of return? Why or why not?

2. Ladle Corporation entered into an agreement with its investment banker to sell 15 million shares of the company's stock with Ladle netting $270 million dollars from the offering. The expected price to the public was $20 per share.

The out-of-pocket expenses incurred by the investment banker were $5,000,000.

a. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $25 per share?

b. What profit or loss would the investment banker incur if the issue were sold to the public at an average price of $15 per share?

If the investment banker agrees to handle the issue on a best efforts basis, earning 7.5 percent of the proceeds, calculate the investment banker's profit or loss if all 15 million shares are sold at an average price of $15. How much will the company receive?

Solution Preview

1. a. How much will the company pay out in dividends if it follows a residual dividend policy?
Capital Budget = 10 million
To be financed through debt = 40%*10 million = 4 million
To be financed through equity = 60%*10 million = 6 million
Net income = 8 million
Dividend paid = 8 million - 6 million = 2 million

b. What is the company's dividend payout ratio if it pays the dividends calculated above?
Dividend payout ratio = 2 million / 8 million = 25%

c. Is it likely the company will follow a residual dividend policy? Why or why not?
Residual dividend policy although keeps the cost of raising fresh ...

Solution Summary

This solution explains finance target capital structure.

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