Question

ALTERNATIVE DIVIDEND POLICIES

In 2015, the Keenan Company paid dividends totaling $2,390,000 on net income of $10 million. Note that 2015 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 4%. However, in 2016, earnings are expected to jump to $17 million and the firm expects to have profitable investment opportunities of $7.4 million. It is predicted that Keenan will not be able to maintain the 2016 level of earnings growth because the high 2016 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2016, the company will return to its previous 4% growth rate. Keenan's target capital structure is 40% debt and 60% equity.

Regular-dividend	$
Extra dividend	$

1. Calculate Keenan's total dividends for 2016 assuming that it follows each of the following policies: (Write out your answers completely. For example, 25 million should be entered as 25,000,000.)
   1. Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. Round your answer to the nearest cent.
      $
   2. 
      
   3. It continues the 2015 dividend payout ratio. Round your answer to the nearest cent. Do not round intermediate calculations.
      $
   4. 
      
   5. It uses a pure residual dividend policy (40% of the $7.4 million investment is financed with debt and 60% with common equity). Round your answer to the nearest cent.
      $
   6. 
      
   7. It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual dividend policy. Round your answer to the nearest cent.
2. 
   
3. Which of the preceding policies would you recommend?
   -Select-Policy 1Policy 2Policy 3Policy 4Item 6
4. 
   
5. Assume that investors expect Keenan to pay total dividends of $10,000,000 in 2016 and to have the dividend grow at 4% after 2016. The stock's total market value is $170 million. What is the company's cost of equity? Round your answer to two decimal places.
   %
6. 
   
7. What is Keenan's long-run average return on equity? [Hint: g = Retention rate x ROE = (1.0 - Payout rate)(ROE).] Do not round intermediate calculations. Round your answer to two decimal places.
   %
8. 
   
9. Does a 2016 dividend of $10,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower?

Answer 1

(1) Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.2016

Dividends = (1.04)(2015 Dividends) = (1.04)($2,390,000) = $2,485,600

(2) It continues the 2015 dividend payout ratio.

2015 Dividend payout ratio = $2,390,000 / $10,000,000 = 0.239 (23.90%)

2016 Dividends = (0.239)(2016 Net income)

                        = (0.239)($17,000,000) = $4,063,000

(3) It uses a pure residual dividend policy (40% of the $7.4 million investment is financed with debt and 60% with common equity)

Equity financing required = (0.60)($7,400,000) = $4,440,000

2016 Dividends = Net income – Equity financing

= $17,000,000 - $4,440,000 = $12,560,000

In this case, all of the equity financing is from retained earnings (net income).

(4) It employs a regular-dividend-plus-extra policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.

Regular dividend component = (1.04)($2,390,000) = $2,485,600

From part (3) above, the residual policy calls for dividends of $12,560,000. Thus, the extra dividend = $12,560,000 - $2,485,600 = $10,074,400

b.

Dividend policy (4), based on the regular dividend with extra payments, seems most logical, particularly if the firm has a target capital structure and ongoing investment funding requirements. If implemented properly, this policy would lead to the correct capital budget and the financing of that budget, and it would also provide appropriate signals to investors and reduce their investment uncertainty

c. Assume that investors expect Keenan to pay total dividends of $10,000,000 in 2016 and to have the dividend grow at 4% after 2016. The stock’s total market value is$170 million. What is the company’s cost of equity?

This can be solved using the discount cash flow (dividend growth model) approach:

Cost of equity (rs) = D1/ P0+ g

= $10,000,000/$170,000,000 + 0.04 = 0.09 (9.00%)

d.What is Keenan’s long-run average return on equity? [Hint: g = Retention rate ´ROE = (1.0 – Payout rate)(ROE)].

growth (g) = Retention rate × ROE

ðROE = g / Retention rate

ðROE = 0.04 / [1 – ($2,390,000/$10,000,000)] = 0.0525 (5.25%)

e. Does a 2016 dividend of $9,000,000 seem reasonable in view of your answers to parts c) and d)? If not, should the dividend be higher or lower? Explain your answer.

A 2016 dividend of $10,000,000 may be a little bit low, given that the firm’s cost of equity is 9% and it is providing an average return on equity (ROE) of 5.25%.

An average return on equity however, implies that there are assets/projects earning less than this return and that the marginal return is less .This suggests that the capital budget is too large and some funds are invested in unprofitable assets, and that instead more dividends should be paid out.