1. Strategic Financing Decisions - Cost of Retained Earnings

Schweser Satellites Inc. produces satellites earth stations that sell for $ 100,000 each. The firm's fixed costs. F, are $2 million; 50 earth stations are produced and sold each year; profits total $ 500,000; and the firm's assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $10,000 and (2) increase output by 20 units, but (3) the sales price on all units will have to be lowed to $95,000 to permit sales of the additional output. The firm has tax loss carry-forwards that cause its tax rate to be zero, its cost of equity is 15 percent, and it uses no debt.

a) Should the firm make the changes?

b) Would the firm's operating leverage increase or decrease if it made the change? What about its breakeven point?

c) Would the new situation expose the firm to more or less business risk than the old one?

2 Explain why agency costs would probably be more of a problem for a large, publicly owned firm that uses both debt and equity capital than for a small, unleveraged firm.

3 Explain; verbally, how MM use the arbitrage process to prove the validity of Proposition 1. Also, list the major MM assumptions and explain why each of these assumptions is necessary in the arbitrage proof.

4 A utility company is supposed to be allowed to charge prices high enough to cover all costs, including its cost of capital. Public service commissions are supposed to take actions to stimulate companies to operate as efficiently as possible in order to keep costs, hence prices, as low as possible. Some time ago, AT & T's debt ratio was about 33 percent. Some people (Myron J. Gordon in particular) argued that a higher debt ratio would lower At & T's cost capital and permit it to charge lower rates for telephone service. Gordon thought an optimal debt ratio for AT & T's was about 50 percent. Do the theories presented in the chapter support or refute Gordon's position?

5 Discuss the pros and cons of having the directors formally announce what a firm's dividend policy will be in the future.

6 Most firms would like to have their stock selling at a high P/E ratio, and they would also like to have extensive public ownership (many different shareholders). Explain how stock dividends or stock splits may help achieve these goals.

7 What is the difference between a stock dividend and a stock split? As a stockholder, would you prefer to see your company declares a 100 percent stock dividend or two-for-one split? Assume that either action is feasible.

8 The cost of retained earnings is less that the cost of new outside equity capital. Consequently, it is totally irrational for a firm to sell a new issue of stock and to pay dividends during the same year." Discuss this statement.