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Answer A:
An increase in long-term debt and preferred stock issues would increase Atrax’s degree of financial leverage and its debt-to-equity ratio. This action has two primary effects from the stockholders’ perspective:
 The variability of earnings per share (EPS) and return on equity will be greater, and EPS and return on equity will increase at a faster rate and be at a higher level whenever the firm earns more than its cost of capital. The increased EPS will exert an upward influence on the value of Atrax’s common stock.
 The variability of EPS and return on equity increases Atrax’s financial risk. This increased risk exposure will exert a downward influence on the common stock value and will be reflected in a lowered price-earnings ratio.
The net effect on the price of Atrax’s common stock will depend upon which influence is stronger. The price of the stock will probably rise because Atrax is continuing to diversify for the purpose of reducing its business risk exposure. Therefore, investors are likely to accept the increased financial risk as long as stockholders believe that Atrax is not over-using debt and preferred stock, i.e., is not going beyond its optimal capital structure.
Answer B:
The short-term effect will probably be a decrease in the market price of Atrax’s common stock. Atrax’s high payout ratio coupled with its limited earnings growth means Atrax has probably attracted conservative investors dependent upon dividend income. These investors will probably sell their stock due to the change in dividend policy. In addition, the elimination of cash dividends may be interpreted by investors that there has been a decrease in earnings.
The long-term effect will probably be an increase in the market price of the stock. The funds diverted from the payment of cash dividends will be used in the capital expansion and diversification program. This should lead to increased earnings in the future while also decreasing Atrax’s business risk. Investors interested in capital gains (rather than dividend income) would probably be attracted to Atrax which should be also result in a positive effect on the market price of the stock.
Answer C:
1. Yes, Traxal would be able to maintain his current equity position of 35% if stock dividends were distributed because all stockholders will receive additional shares of stock in proportion to their current ownership interest in Atrax.
2. The probable short-term effect would be a decrease in the market price of Atrax’s stock, because current investors will seek to sell their stock as a consequence of the change in dividend policy and the implied connotations of reduced earnings. The stock dividends give no substantive value to the stockholder who expects a cash dividend. However, the price of the stock may not fall as much as reducing the payout ratio to zero because some current investors may misinterpret the nature of a stock dividend or may accept the reduced cash dividends in the short-term when coupled with the hope for potential capital gains in the long-term.
3. The probable long-term effect would be an increase in the market price of Atrax’s stock because growth-oriented investors should be attracted to Atrax for the capital gain potential. In addition, a nominal dividend payout will act as a downward stabilizer on stock price movements. Furthermore, if Atrax’s diversification program is successful, the reduced business risk and increased future earnings should exert a positive influence on the stock price.
4. Proposal 2 is more likely to result in a smaller drop in the stock price than Proposal 3 in the short-term due to the higher cash dividends and less negative reaction to an implied earnings decline. The long-term effect on stock prices is less certain. Proposal 3 would probably result in higher stock prices due to increased future earnings growth because all internally generated funds could be reinvested.