Question: Ybor City Tobacco Company has for many years enjoyed a

Ybor City Tobacco Company has for many years enjoyed a moderate but stable growth in sales and earnings. In recent times, however, cigar consumption and consequently Ybor’s sales have been falling, primarily because of the public’s greater awareness of the health dangers associated with smoking. Anticipating further declines in tobacco sales in the future Ybor’s management hopes eventually to move almost entirely out of the tobacco business and into a newly developed, diversified product line in growth-oriented industries. The company is especially interested in the prospects for pollution-control devices because its research department has already done much work on the problems of filtering smoke. Right now, the company estimates that an investment of $15 million will be necessary to purchase new facilities and to begin production of these products, but the investment could earn a return of about 18 percent within a short time. The only other available investment opportunity costs $6 million and is expected to return about 10.4 percent. The company is expected to pay a $3.00 dividend on its 3 million outstanding shares, the same as its dividend last year. The directors could be persuaded to change the dividend if there are good reasons for doing so. Total earnings after taxes for the year are expected to be $14.25 million; the common stock is currently selling for $56.25 per share; the firm’s target debt/assets ratio is 45 percent; and its marginal tax rate is 40 percent. The costs of various forms of financing are as follows:
New bonds, rd = 11% (the before-tax rate)
New common stock sold at $56.25 per share will net $51.25
Required rate of return on retained earnings, rs = 14%
a. Calculate Ybor’s expected payout ratio, the break point at which the marginal cost of capital (MCC) rises, and its MCC above and below the point of exhaustion of retained earnings at the current payout. (rs is given, and D1 / P0 can be found; then, knowing rs and D1 / P0, you can determine g.)
b. How large should Ybor’s capital budget be for the year?
c. What is an appropriate dividend policy for Ybor? How should it finance the capital budget?
d. How might risk factors influence Ybor’s cost of capital, capital structure, and dividend policy?
e. What assumptions, if any, do your answers to the preceding parts make about investors’ preferences for dividends versus capital gains (in other words, what are investors’ preferences regarding the D1 = P0 and g components of rs)?

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