Question

In 2015, the Keenan Company paid dividends totaling $2,340,000 on net income of $13.6 million. Note that 2015 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 7%. However, in 2016, earnings are expected to jump to $20.4 million and the firm expects to have profitable investment opportunities of $10.2 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 7% 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 $10.2 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 $7,000,000 in 2016 and to have the dividend grow at 7% after 2016. The stock's total market value is $200 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 $7,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower?
   -Select-YesNo, it should be lowerNo, it should be higher

Answer 1

a.

1) Compuatation of Keenan's total dividends for 2016 using growth rate:

Dividend for 2015 = $2,340,000

Growth rate = 7%

Expected dividend for the year 2016= $2,340,000 * (1+7%) = $2,503,800.00

2) Compuatation of Keenan's total dividends for 2016 using dividend ratio:

Dividend payout ratio for 2015 = Dividend / Net Income * 100 = $2,340,000 / $13,600,000 * 100 = 17.21%

=> Dividend for 2016 = Expected net income * dividend payout ratio = $20,400,000 * 17.21% = $3,510,840.00

3) If Keenan Company opts for pure dividend policy:

1	Keenan's net income for 2016(expected)	$ 20,400,000.00
2	Debt equity ratio	40:60
3	Inestment oppertunity available	$ 10,200,000.00
4=3*60%	Investment in equity (10.2m * 60%)	$    6,120,000.00
5=1-4	Residual income portion which is to be distributed as dividend	$ 14,280,000.00

4)f Keenan Companyemploys a regular-dividend-plus-extras policy:

1	Keenan's net income for 2016(expected)	$ 20,400,000.00
2	Debt equity ratio	40:60
3	Inestment oppertunity available	$ 10,200,000.00
4=3*60%	Investment in equity (10.2m * 60%)	$    6,120,000.00
5=1-4	Residual amount	$ 14,280,000.00
6= a(1)	Dividend as per long term growth rate (1)	$    2,503,800.00
7=5-6	Extra dividend	$ 11,776,200.00

Therefore,

Regular dividend = $2,503,800.00

Extra dividend = $11,776,200.00

b.

Earnings are expected to spike in the coming one year only. Since there is an expectation that normal growth rate restores after the next year, it is recommended to follow the existing regular dividend policy only.

c.

Cost of equity = [expected dividend / Market value] + growth rate = [$7,000,000 / $200,000,000] + 0.07 =

=> = 0.035+0.07 = 0.105 = 10.50%

d. Keenan's long-run average return on equity:

Long run average return on equity can be computed using the following formula

Growth, g = (1-dividend payout ratio) * return on equity

=> Return on equity = g / (1-dividend payout ratio)

=> ROE = 0.07 / (1-0.1721) = 0.07 / 0.8279 = 8.46%

e.

No, it should be lower

It is not reasonable and it should be lower.