Question

In: Finance

Residual dividend policy. As president of​ Young's of​ California, a large clothing​ chain, you have just...

Residual dividend policy. As president of​ Young's of​ California, a large clothing​ chain, you have just received a letter from a major stockholder. The stockholder asks about the​ company's dividend policy. In​ fact, the stockholder has asked you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend​ payment, but you do know the​ following:

​(1) The company follows a residual dividend policy.

​(2) The total capital budget for next year is likely to be one of three​ amounts, depending on the results of capital budgeting studies that are currently underway. The capital expenditure amounts are ​$2 ​million, ​$3 ​million, and ​$4 million.

​(3) The forecasted level of potential retained earnings next year is ​$2 million.

​(4) The target or optimal capital structure is a debt ratio of 45​%. You have decided to respond by sending the stockholder the best information available to you.

a.  Compute the amount of the dividend​ (or the amount of new common stock​ needed) and the dividend payout ratio for each of the three capital expenditure amounts.

b.  ​Compare, contrast, and discuss the amount of dividends​ (calculated in part a​) associated with each of the three capital expenditure amounts.

Solutions

Expert Solution

Under residual dividend policy, earnings available after meeting all profitable projects are distributed as dividends
Capex        2,000,000        3,000,000       4,000,000
To be financed throught Equity 55%        1,100,000        1,650,000       2,200,000
Net Income        2,000,000        2,000,000       2,000,000
Dividends = Net Income- To be financed through Equity            900,000           350,000 0
Payout ratio = Dividend/Earnings 45.00% 17.50% 0.00%
Higher the capital expenditure, lower will be the dividends and hence, lower will be the payout ratio

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