Question

Problem 14-09 Residual Distribution Policy Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose, each of which requires a $3 million investment. These projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and costs of capital are as follows:

Project A: Cost of capital = 16%; IRR = 17% Project B: Cost of capital = 14%; IRR = 15%

Project C: Cost of capital = 7%; IRR = 9%

Harris intends to maintain its 40% debt and 60% common equity capital structure, and its net income is expected to be $14,387,500. If Harris maintains its residual dividend policy (with all distributions in the form of dividends), what will its payout ratio be? Round your answer to two decimal places.

Answer 1

Solution:
	Payout ratio = 62.47%
Working Notes:
	In Residual Distribution Policy , leftover equity is payout as dividend.
	In the given case all the three projects have cost of capital lower than theirs IRR, so all the three projects should be accepted.
	Investment required = 3 x $3 million = $9 million
	out of this investment 60% should come from Equity, to maintain debt equity ratio.
	Amount be financed from equity = 60% x $9 million
		=$5.4 million
	Dividend = Net income - Amount to be financed from Equity
	Dividend = $14,387,500 - $5,400,000
	Dividend = $8,987,500
	Payout ratio = Dividend / Net income
	Payout ratio = $8,987,500 / $14,387,500
	Payout ratio = 0.624674196
	Payout ratio = 62.47%
Please feel free to ask if anything about above solution in comment section of the question.