# Working capital, dividends, effective and average tax rate

DeBauge Realtors, Inc., is a realty firm owned by Jeff and Kristi DeBauge. The DeBauge family owns 100% of the corporation's stock. The following summarized data (in thousands) are taken from the December 31, 2010, financial statements:

For the Year Ended December 31, 2010:

Commissions revenue $145

Cost of services provided 61

Advertising expense 27

________

Operating income $ 57

Interest expense 5

Income tax expense 19

Net income $ 33

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At December 31, 2010:

Assets

Cash and short-term investments $ 31

Accounts receivable, net 42

Property, plant, and equipment, net 124

Total assets $ 197

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Liabilities and Owners' Equity

Accounts payable $ 93

Income taxes payable 8

Notes payable (long term) 48

Paid-in capital 23

Retained earnings 25

Total liabilities and owners' equity $ 197

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At December 31, 2009, total assets were $204 and total owners' equity was $48. There were no changes in notes payable or paid-in capital during 2010.

Calculate the effective interest rate on the notes payable for DeBauge Realtors, Inc. (Round your answer to 2 decimal places.)

Effective interest rate ______ %

Calculate the company's average income tax rate. (Hint: You must first determine the earnings before taxes.) (Round your answer to the nearest whole percent. )

Average income tax rate _______ %

Calculate the amount of dividends declared and paid to Jeff and Kristi DeBauge during the year ended December 31, 2010. (Hint: Do a T-account analysis of retained earnings.) (Amounts should be entered in the full amount and not in 000s. (Example - enter 20,000 and not 20). Since dividends are a deduction from retained earnings, enter the amount of dividends with a minus sign.)

Dividends declared and paid $ _________

Calculate the amount of working capital and the current ratio at December 31, 2010. (Negative amount should be indicated by a minus sign. Amounts should be entered in the full amount and not in 000s. (Example - enter 20,000 and not 20). Round your ratio answer to 2 decimal places.)

Working capital $ ________

Current ratio _____________

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#### Solution Preview

Calculate the effective interest rate on the notes payable for DeBauge Realtors, Inc. (Round your answer to 2 decimal places.)

Effective interest rate 10.42 %

Because the notes payable did not change in 2010, its principal balance was $48,000 throughout the year. Interest expense was $5,000 in 2010.

Effective interest rate = $5,000/$48,000

Effective interest rate = 10.42 percent

Calculate the company's average income tax rate. (Hint: You must first determine the earnings before taxes.) (Round your answer to the nearest whole percent. )

Average income tax rate 37 %

Taxable income = Operating income - Interest expense

Taxable income = $57,000 - $5,000

Taxable income ...

#### Solution Summary

This solution illustrates how to compute working capital, dividends, effective and average tax rate.

33 questions on Capital Structure, Market value of the firm, stock price, estimated cost of equity, dividends, bonds, working capital, etc: Please see attached for full questions

1. A consultant has collected the following information regarding Young Publishing:

Total assets $3,000 million Tax rate 40%

Operating income (EBIT) $800 million Debt ratio 0%

Interest expense $0 million WACC 10%

Net income $480 million M/B ratio 1.00×

Share price $32.00 EPS = DPS $3.20

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the total market value of the firm? (The answers are in millions.)

2. Dabney Electronics currently has no debt. Its operating income is $20 million and its tax rate is 40 percent. It pays out all of its net income as dividends and has a zero growth rate. The current stock price is $40 per share, and it has 2.5 million shares of stock outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent equity (based on market values), its investment bankers believe its weighted average cost of capital would be 10 percent. What would its stock price be if it changes to the new capital structure?

3. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20 percent debt and 80 percent equity, based on market values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk premium, rM - rRF, is 5 percent. Currently the company's cost of equity, which is based on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon's estimated cost of equity if it were to change its capital structure to 50 percent debt and 50 percent equity?

4. Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:

Percent financed Percent financed Debt-to-equity Bond Before-tax

With debt (wd) with equity (wc) ratio (D/S) rating cost of debt

0.10 0.90 0.10/0.90 = 0.11 AA 7.0%

0.20 0.80 0.20/0.80 = 0.25 A 7.2

0.30 0.70 0.30/0.70 = 0.43 A 8.0

0.40 0.60 0.40/0.60 = 0.67 BB 8.8

0.50 0.50 0.50/0.50 = 1.00 B 9.6

The company's tax rate, T, is 40 percent.

The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.)

On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

The following data are required for the next 3 problems.

The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero-growth company. AJC's current cost of equity is 8.8 percent, and its tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.

5. What is AJC's current total market value and weighted average cost of capital?

6. Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50 percent debt and 50 percent equity. If it makes this change, its resulting market value would be $820,000. What would be its new stock price per share?

7. Now assume that AJC is considering changing from its original capital structure to a new capital structure that results in a stock price of $64 per share. The resulting capital structure would have a $336,000 total market value of equity and $504,000 market value of debt. How many shares would AJC repurchase in the recapitization?

8. Your company has decided that its capital budget during the coming year will be $20 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) are projected to be $34.667 million for the year. The company has $200 million of assets; its average interest rate on outstanding debt is 10 percent; and its tax rate is 40 percent. If the company follows the residual dividend policy and maintains the same capital structure, what will its dividend payout ratio be?

9. Flavortech Inc. expects EBIT of $2,000,000 for the current year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. For the next year, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio?

10. The following facts apply to your company:

Target capital structure: 50% debt; 50% equity.

EBIT: $200 million.

Assets: $500 million.

Tax rate: 40%.

Cost of new and old debt: 8%.

Based on the residual dividend policy, the payout ratio is 60 percent. How large (in millions of dollars) will the capital budget be?

11. S. Claus & Company is planning a zero coupon bond issue. The bond has a par value of $1,000, matures in 2 years, and will be sold at a price of $826.45. The firm's marginal tax rate is 40 percent. What is the annual after-tax cost of debt to the company on this issue?

12. A 15-year zero coupon bond has a yield to maturity of 8 percent and a maturity value of $1,000. What is the amount of tax that an investor in the 30 percent tax bracket would pay during the first year of owning the bond?

13. Machina Corporation is financing an ongoing construction project. The firm needs $8 million of new capital during each of the next three years. The firm has a choice of issuing new debt and equity each year as the funds are needed, or issuing the debt now and the equity later. The firm's capital structure is 40 percent debt and 60 percent equity. Flotation costs for a single debt issue would be 1.6 percent of the gross debt proceeds. Yearly flotation costs for three separate issues of debt would be 3.0 percent of the gross amount. Ignoring time value effects due to timing of the cash flows, what is the absolute difference in dollars saved by raising the needed debt all at once in a single issue rather than in three separate issues?

14. U.S. Delay Corporation, a subsidiary of the Postal Service, must decide whether to issue zero coupon bonds or quarterly payment bonds to fund construction of new facilities. The 1,000 par value quarterly payment bonds would sell at $795.54, have a 10 percent annual coupon rate, and mature in ten years. At what price would the zero coupon bonds with a maturity of 10 years have to sell to earn the same effective annual rate as the quarterly payment bonds?

15. Lackner Bros. has 12 percent semiannual bonds outstanding which mature in 10 years. Each bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company must replace the bonds with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be, in order for it to be profitable to call the bonds today? (That is, what is the "breakeven rate"?)

16. For the Cook County Company, the average age of accounts receivable is 60 days, the average age of accounts payable is 45 days, and the average age of inventory is 72 days. Assuming a 365-day year, what is the length of the firm's cash conversion cycle?

17. Rojas Computing is developing a new software system for one of its clients. The system has an up-front cost of $75 million (at t = 0). The client has forecasted its inventory levels for the next five years as shown below:

Year Inventory

1 $1.0 billion

2 1.2 billion

3 1.6 billion

4 2.0 billion

5 2.2 billion

Rojas forecasts that its new software will enable its client to reduce inventory to the following levels:

Year Inventory

1 $0.8 billion

2 1.0 billion

3 1.4 billion

4 1.7 billion

5 1.9 billion

After Year 5, the software will become obsolete, so it will have no further impact on the client's inventory levels. Rojas' client is evaluating this software project as it would any other capital budgeting project. The client estimates that the weighted average cost of capital for the software system is 10 percent. What is the estimated NPV (in millions of dollars) of the new software system?

18. Bowa Construction's days sales outstanding is 50 days (on a 365-day basis). The company's accounts receivable equal $100 million and its balance sheet shows inventory equal to $125 million. What is the company's inventory turnover ratio?

19. Gaston Piston Corp. has annual sales of $50,735,000 and maintains an average inventory level of $15,012,000. The average accounts receivable balance outstanding is $10,008,000. The company makes all purchases on credit and has always paid on the 30th day. The company is now going to take full advantage of trade credit and pay its suppliers on the 40th day. If sales can be maintained at existing levels but inventory can be lowered by $1,946,000 and accounts receivable lowered by $1,946,000, what will be the net change in the cash conversion cycle? (Assume there are 365 days in the year.)

20. Hayes Hypermarket purchases $4,562,500 in goods over a 1-year period from its sole supplier. The supplier offers trade credit under the following terms: 2/15, net 50 days. If Hayes chooses to pay on time but not to take the discount, what is the average level of the company's accounts payable, and what is the effective annual cost of its trade credit? (Assume a 365-day year.)

21. Allen Brothers is interested in increasing its free cash flow (which it hopes will result in a higher EVA and stock price). The company's goal is to generate $180 million of free cash flow over the upcoming year. Allen's CFO has made the following projections for the upcoming year:

? EBIT is projected to be $850 million.

? Gross capital expenditures are expected to total $360 million, and its depreciation expense is expected to be $120 million. Thus, its net capital expenditures are expected to total $240 million.

? The firm's tax rate is 40 percent.

The company forecasts that there will be no change in its cash and marketable securities, nor will there be any changes in notes payable or accruals. What changes in accounts receivable, inventory, and accounts payable will enable the company to achieve its goal of generating $180 million in free cash flow?

22. A firm with no debt has 200,000 shares outstanding valued at $20 each. Its cost of equity is 12%. The firm is considering adding $1,000,000 in debt to its capital structure. The coupon rate would be 8% and the firm's tax rate is 34%. What would the firm be worth after adding the debt?

23. Suppose a firm issues perpetual debt with a face value of $5,000 and a coupon rate of 12%. If the firm is subject to a 40% tax rate and the appropriate discount rate is 10%, what is the present value of the interest tax shield?

24. A firm has 10,000 bonds outstanding, each with a face value of $1,000 and a coupon payment of $55 every six months. If the corporate tax rate is 34%, what is the interest tax shield each year?

25. A firm has a WACC of 16%, a cost of debt of 10% and a cost of equity of 22%. What is the firm's debt-to-equity ratio? Ignore taxes.

26. BDJ Inc. has 31,000 shares of stock outstanding with a market price of $15 per share. If net income for the year is $155,000 and the retention ratio is 80%, what is the dividend per share on BDJ Inc.'s stock?

27. Lucky Mike's, Inc. has a target debt/equity ratio of .75. After-tax earnings for 1996 were $850,000 and the firm needs $1,150,000 for new investments. If the company follows a residual dividend policy, what dividend will be paid?

Use the following information to answer the next 6 questions.

Consider the firm, Alex, Inc. which is financed with 100% equity. The firm has 100,000 shares of stock outstanding, with a market price of $5 per share. Total earnings for the most recent year are $50,000. The firm has cash of $25,000 in excess of what is necessary to fund its positive NPV projects. The firm is considering using the cash to pay an extra dividend of $25,000 or to repurchase stock in the amount of $25,000. The firm has other assets worth $475,000(market value). For each of the following 6 questions, assume that there are no transaction costs, taxes or other market imperfections.

28. Assume the firm pays the $25,000 excess cash out in the form of a cash dividend. What will the firm's earnings per share be after the dividend?

29. Assume the firm pays the $25,000 excess cash out in the form of a cash dividend. What will the market price of a share of Alex's stock be after the dividend?

30. Assume the firm pays the $25,000 excess cash out in the form of a cash dividend. Also assume you owned 1,000 shares before the dividend was paid and that this was your total wealth. Immediately after the dividend is paid, what is your total wealth?

31. Assume the firm uses the $25,000 excess cash to buy back stock at $5 per share. What will the firm's earnings per share be after the repurchase?

32. Assume the firm uses the $25,000 excess cash to buy back stock at $5 per share. What will the firm's P/E ratio be after the share repurchase?

33. Assume the firm uses the $25,000 excess cash to buy back stock at $5 per share. What will the market price of a share of Alex's stock be after the share repurchase?

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