Sonny Costin, CFA, is a portfolio manager for Summit Partners, an investment firm whose clients are primarily high net worth individuals. Costin has conducted considerable research on a possible investment in the common shares of ATCO, a major manufacturer of pharmaceuticals in the U.S. and Europe. Costin feels that the potential for capital appreciation for the shares of ATCO is high, given the fact that the company is preparing to release later this year a new “breakthrough” drug for the prevention of diabetes. According to his analysis, the shares of ATCO are currently undervalued by approximately 15 to 20%, but Costin attributes the price depression to a negative broad market sentiment rather than the fundamentals of the company itself. He believes that once investors’ sentiment favors the market again, the shares should be poised for significant appreciation.

With the successful introduction of the new drug, Costin anticipates that ATCO’s gross revenues and net income will rise substantially in the near term. One critical question in the evaluation of the purchase of ATCO shares is the most probable dividend policy that will be enacted by the company’s management team. Costin is reviewing the past financial statements of ATCO, examining the company’s past dividend policies for possible clues that would be helpful in the prediction of the company’s future dividend policy. ATCO’s management stated in the most recent financial statements that it intends to continue paying out a cash dividend to the common shareholders for the foreseeable future. In addition, management outlined a dividend plan, to be initiated this year, that has a 25% target payout ratio and with the plan to bring the dividend up to the target payout ratio over the next three years. Costin believes that management will most likely abide by its stated policy, but wants to evaluate other possible dividend policy scenarios and their effect on the common shares of the company.

According to his analysis, Costin predicts that next year, ATCO’s earnings will rise from last year’s $2.25 per share to $4.10 per share in 2008. Last year, in 2007, the company paid $.55 in the form of a cash dividend to all common shareholders. There are 15,000,000 common shares outstanding, and the current market price is $26.00 per share. The company has a committed line of credit that provides up to $25,000,000 at a 9.25% after-tax cost of borrowing.

Assuming that ATCO has a 25% target payout ratio and plans to bring the dividend up to the target payout ratio over the next three years, calculate next year’s expected dividend.

A) $0.70 per share.

B) $0.46 per share.

C) $1.02 per share.

Assuming that ATCO has a 25% target payout ratio and plans to bring the dividend up to the target payout ratio over the next three years, which of the following statements is most accurate? While next year’s earnings are expected to increase 54%, next year’s payout ratio:

A) will incrementally increase as well.

B) will actually decrease.

C) is expected to remain at the stated 25% target.

Management of a corporation may consider the implications of its actions on shareholders when establishing a dividend policy. One school of thought is that in general, shareholders prefer the payout of a cash dividend “today” rather an anticipated capital gain “tomorrow”. This theory of investor preference toward dividend policy is called:

A) the dividend irrelevance theory, because dividend policy has no effect whatsoever on the price of a company’s stock or its cost of capital.

B) the dividend preference theory, because today’s dividend has less risk than tomorrow’s capital gain.

C) tax aversion theory, because typically dividends are taxed at a lower rate than capital gains.

Assume that ATCO management now changes its stated dividend policy, and announces that instead of paying a cash dividend, it intends to utilize the same dollar amount to repurchase outstanding shares of ATCO common stock. Ignoring potential tax consequences, which of the following statements concerning the share repurchase is most accurate?

A) A share repurchase has the same impact on shareholder wealth as a cash dividend payment of an equivalent amount.

B) Shareholders will prefer the share repurchase to a cash dividend because the book value per share will increase by the amount of the investment in company shares.

C) A share repurchase program would be to the greatest benefit to those current shareholders who have the lowest basis in the stock.

Assume that ATCO management now changes it stated dividend policy, and announces that it intends to borrow $19,500,000 to repurchase 750,000 shares. Calculate the approximate 2008 EPS after the stock buyback.

A) $4.31

B) $4.19

C) $4.10

Assume that after a share repurchase, the resulting EPS of a company’s stock is lower than the pre-repurchase EPS. Which of the following statements is most accurate?

A) The pre-tax borrowing cost is greater than the earnings yield of the shares.

B) The after-tax borrowing cost is less than the earnings yield of the shares.

C) The after-tax borrowing cost is greater than the earnings yield of the shares.

Last year, Calfee Multimedia had earnings of $4.00 per share and paid a dividend of $0.30. In the current year, the company expects to earn $5.20 per share. Calfee has a 30% target payout ratio. If the expected dividend for this year is $0.39, what time period is Calfee most likely using in order to bring its dividend up to the target payout?

A) 8 years.

B) 3 years.

C) 4 years.

Manthey Studios uses a target payout adjustment approach in paying its annual dividend. Last year, Manthey had earnings per share (EPS) of $2.50 and paid a dividend of $0.30 per share. This year, Manthey estimates its EPS will be $3.20. Manthey has a target payout ratio of 28% and uses a 5 year period to adjust its dividend. Which of the following is closest to Manthey’s expected dividend per share?

A) $0.59.

B) $0.42.

C) $0.34.

Rombauer Metals uses a target payout adjustment approach in paying its annual dividend. Last year, Rombauer had earnings per share (EPS) of $0.60 and paid a dividend of $0.08 per share. This year, Rombauer estimates its EPS will be $0.90. What is Rombauer’s expected dividend per share if the firm has a target payout ratio of 40% and uses a 4 year period to adjust its dividend?

A) $0.15.

B) $0.11.

C) $0.09.

Lazenby Home Builders has a target dividend payout ratio of 25%. Last year, Lazenby earned $2.00 per share and paid a dividend of $0.25. This year, new home starts are expected to decline significantly and Lazenby expects to earnings to decline to $1.80 per share. Which of the following scenarios is least likely? Lazenby Home Builders:

A) cuts its dividend by 10%.

B) maintains its dividend at $0.25 per share.

C) increases its dividend by 50%.