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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

RESIDUAL DIVIDEND MODEL Walsh Company is considering three independent projects, each of which requires a $4 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=19%
Project M (medium risk): Cost of capital=12% IRR=13%
Project L (low risk). Cost of capital=9% IRR=8%

Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of $7,500,000. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio?

Summary Introduction

To calculate: Payout ratio.

Introduction:

Residual Dividend Policy:

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

Explanation

Calculate payout ratio.

Given,

Net income is $7,500,000.

Calculated,

Dividend payment is $2,700,000.

Formula to calculate payout ratio:

PayoutRatio=DividendPaymentTotalEarnings×100

Substitute $7,500,000 for total earnings and $2,700,000 for dividend payment

Payoutratio=$2,700,000$7,500,000×100=36%

Working note:

Calculate equity required,

Given,

Capital budget is $8,000,000 (4,000,000×2)

Equity percentage in capital structure is 60%

Formula to calculate equity required:

Equityrequired=CapitalBudget×%ofEquity

Substitute $8,000,000

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