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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

RESIDUAL DIVIDEND MODEL Welch Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here:

Project H (high risk): Cost of capital = 16% IRR = 20%
Project M (medium risk): Cost of capital = 12% IRR = 10%
Project L (low risk): Cost of capital = 8% IRR = 9%

Note that the projects’ costs of capital vary because the projects have different levels of risk. The company’s optimal capital structure calls for 50% debt and 50% common equity, and it expects to have net income of $7,287,500. If Welch establishes its dividends from the residual dividend model, what will be its payout ratio?

Summary Introduction

To calculate: Payout ratio.

Residual Dividend Policy:

Under the residual dividend policy, first preference is given to the current capital investment by the company the amount remained after the capital investment is distributed among the shareholders as dividend.

Explanation

Calculate equity required.

Given,

Capital budget is $10,000,000 (5,000,000×2).

Equity percentage in capital structure is 50%

Formula to calculate equity required,

Equityrequired=CapitalBudget×%ofEquity

Substitute $10,000,000 for capital budget and 50% for equity percentage.

Equityrequired=$10,000,000×50%=$5,000,000

So, total equity required for capital project is $5,000,000.

Calculate residual dividend payment.

Given,

Net income is $7,287,500.

Earning retained for project is $5,000,000.

Formula to calculate residual dividend payment

Residualdividendpayment=NetIncomeEarningsretained

Substitute $7,287,500 for net income and $5,000,000 for earning retained for project

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