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Example Problems

1. Firm A had the following selected items on its balance sheet:

 Cash \$28,000,000 Common stock (\$50 par, 2,000,000 shares outstanding) 100,000,000 Additional paid-in capital 10,000,000 Retained earnings 62,000,000

How would each of these accounts appear after:

a. A cash dividend of \$1 per share?

b. A 5 percent stock dividend (fair market value is \$100 per share)?

c. A one-for-two reverse split?

Solution:

a. After the dividend is declared, retained earnings are reduced and current liabilities are increased by the amount of the dividend, in this case, 2,000,000 x \$1. When the dividend is paid, cash and current liabilities are reduced by \$2,000,000. The net effect is that cash becomes \$26,000,000 and retained earnings decline to \$60,000,000.

 Cash \$26,000,000 Common stock (\$50 par, 2,000,000 shares outstanding) 100,000,000 Additional paid-in capital 10,000,000 Retained earnings 60,000,000

b. A stock dividend does not affect a firm’s assets or liabilities. It is a recapitalization that transfers an entry from retained earnings to common stock and additional paid-in capital.

In this example, the 5% stock dividend results in 100,000 shares (2,000,000 x .05) being issued. They have a market value of \$10,000,000 (100,000 x \$100) so retained earnings are reduced to \$52,000,000. \$5,000,000 (100,000 x \$50 par value). Retained earnings are reduced to \$52,000,000. \$5,000,000 is credited to common stock (for a total of \$105,000,000). The remaining \$5,000,000 is credited to additional paid-in capital (for a total of \$15,000,000).

 Cash \$28,000,000 Common stock (\$50 par, 2,000,000 shares outstanding) 105,000,000 Additional paid-in capital 15,000,000 Retained earnings 52,000,000

c. A stock split does not affect the firm’s assets or liabilities. It only alters the number of shares, their par value, and the price of the stock. In this case (a one for two reverse stock split), two old shares become one new share, and the par value of the new share is doubled.

 Cash \$28,000,000 Common stock (\$100 par, 1,000,000 shares outstanding) 100,000,000 Additional paid-in capital 10,000,000 Retained earnings 62,000,000

2. The dividend-growth model may be used to value a stock: g)

k

(

g))

1

(

(

0

¸

+

=

D

V

a. What is the value of a stock if:

D0= \$2

k = 10%

g = 6%

b. What is the value of the stock if the dividend is increased to \$3 and the other variables remain constant?

c. What is the value of this stock if the required return declines to 7.5 percent and the other variables remain constant?

d. What is the value of this stock if the growth rate declines to 4 percent and the other variables remain constant?

e. What is the value of this stock if the dividend is increased to \$2.30, the growth rate declines to 4 percent, and the required return remains 10 percent?

Solution:

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