Question

FarmCo, Inc. follows a policy of paying out cash dividends equal to the residual amount that remains after funding 40 percent of its planned capital expenditures. The firm tries to maintain a 40 percent debt and 60 percent equity capital structure and does not plan on issuing more stock in the coming year.​ FarmCo's CFO has estimated that the firm will earn $12 million in the current year.

a. If the firm maintains its target financing mix and does not issue any equity next​ year, what is the most it could spend on capital expenditures next year given its earnings​ estimate?

b. If​ FarmCo's capital budget for next year is $10 million, how much will the firm pay in dividends and what is the resulting dividend payout​ percentage?

Answer 1

A.

Target capital structure debt = 40%  
Equity =    60%
  
Forecasted net income =   12000000
  
Firm cannot issue no new stock. So with net income of $12000000, company can retain maximum $12000000 earnings for capital budget.  
So maximum equity portion of budget =   12000000
maximum capital budget = Equity portion/Equity percentage*1  
12000000/60% *1  
  
20000000  
Do, maximum capital budget consistent with debt and equity ratio is $   20000000
or $20 million  
  

B.

Capital budget =   10,000,000
Target capital structure debt = 40%  
Equity =   60%
  
Equity portion of budget financed with Retained earnings = 10000000*60% =   $6,000,000.00
So, this amount of $6,000,000 will be retained from net income  
Residual Dividend paid =12000000-6000000=   $6,000,000.00

Payout % = Dividend / net income

6000000/12000000

=50%

So residual Dividend is $6000000 and payout % is 50%