Question

Lane Industries is considering three independent projects, each of which requires a $2.5 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 = 13%	IRR = 15%
Project M (medium risk):	Cost of capital = 10%	IRR = 8%
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 40% debt and 60% common equity, and it expects to have net income of $3,100,000. If Lane establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to 2 decimal places.

Answer 1

Expected Dividend Payout Ratio using residual dividend model

Step-1, Determination of total Investment cost by comparing the Project’s IRR with their cost of capital

We know that the project should be accepted only if the IRR is greater than the cost of capital. Here, the IRR for the Project H and Project L are greater than their cost of capital and therefore, the Project H and Project L should be accepted.

Hence, the total Investment cost will be $5,000,000 [$2,500,000 x 2]

Step-2, Calculation of Total Dividend paid

Total Dividend paid using the residual dividend policy is calculated as follows

Total Dividend = Net Income – [Total Capital Budget x Equity Ratio]

= $3,100,000 – [$5,00,000 x 60%]

= $3,100,000 - $3,000,000

= $100,000

Step-3, The Expected Dividend Payout Ratio for this year

Therefore, the Expected Dividend Payout Ratio = [Total Dividend Paid / Net Income] x 100

= [$100,000 / $3,100,000] x 100

= 3.23%

“Hence, the Expected Dividend Payout Ratio will be 3.23%”