Question

Nucor Corporation manufactures and sells steel and steel products. It operates in three segments: Steel Mills, Steel Products, and Raw Materials. The Steel Mills segment produces hot-rolled, cold-rolled, and galvanized sheet steel products; plate steel products; wide-flange beams, beam blanks, and H-piling and sheet piling products; bar steel products, such as blooms, billets, concrete reinforcing and merchant bars, and special bar quality products. It also engages in the steel trading and rebar distribution businesses. Nucor has a capital budget of $1,350,000. Nucor wants to maintain a target capital structure of 40% debt and 60% equity. The company forecasts net income this year to be $800,000.

Required:

1. If Nucor follows a residual distribution policy (with all distributions paid in the form of dividends) and the equity portion of the capital structure is financed using net income, compute the dividend payout ratio?

2. How do you know if a dividend is safe? Discuss.

Answer 1

Answer :

Capital Budget = $ 13,50,000

Capital Structure :

Debt (40%) = $ 5,40,000

Equity (60%) = $ 8,10,000

Forecasted Net Income = $ 8,00,000

Now, Under Residual distribution Policy as the name suggests the Cash is not kept in the Business the it is re-invested in the business by retaining the amount of Net Income equal to the amonunt of Equity capital and the remaining amount is distributed to equity Shareholders in the form of dividends .

So, basically under this approach we are firstly retaining the 100% of theNet Income or retained earnings on the Capital Expenditure and balance amount is distributed as dividend.

In the given question, Capital Expenditure is $ 13,50,000 and Equity portion of $ 8,10,000 will be financed using Net Income which is $ 8,00,000. So, Entire Net Income is used in Equity portion and Therefore, Nothing left to pay as dividend to equity shareholders.

Dividend Payout Ratio = Dividend Paid / Net Earnings Available to Equity Shareholders .

Since No Dividend paid as entire Net Income of $ 8,00,000 used in the Financing of Equity portion of Capital Structure,

So, Dividend Payout Ratio is Zero.

2 How do you know if a dividend is safe ?

Equity financed out of total capital structure is 60% .

So, What is left after paying out as interest expenses on debt raised and taxes is left for equity shareholders of the company .

Now , What is left for Equity Shareholders can either be retained to reinvest in the company or it can be distributed to equity shareholders in the form of dividends.

And under Residual Distribution policy , amount remaining after paying out the capital expenditure (means making reinvestment ) is distributed as dividend .

So, Dividend ratio is unpredictale since it could be paid only after financing the capital expenditures .

Extra Income Left will all be distributed to shareholders in the form of dividends.