Question

D. Paul Inc. forecasts a capital budget of $775,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and she also wants to pay a dividend of $650,000. If the company follows the residual dividend model, how much income must it earn, and what will its dividend payout ratio be?

Answer 1

Solution :

(a)

As per the information given in the question

Dividends paid = $ 650,000   ; Equity % in Target capital structure = 55 % = 0.55 ;

Debt % in Target capital structure = 45 % = 0.45 ; Forecasted capital budget = $ 775,000   ;

As per the Residual Dividend model

Dividends paid = Net Income – ( Equity % in Target capital structure * Capital budget )

Applying the available information in the model we have

$ 650,000 = Net Income – ( 0.55 * $ 775,000 )

$ 650,000 = Net Income – $ 426,250

$ 650,000 + $ 426,250 = Net Income

Net Income = $ 650,000 + $ 426,250

Net Income = $ 1,076,250

(b)

The formula for calculating dividend payout ratio is

= Dividends paid / Net Income

Applying the available information we have dividend payout ratio is

= $ 650,000 / $ 1,076,250

= 0.603949

= 60.3949 %

= 60.40 % ( when rounded off to two places )

Thus the Dividend payout ratio = 0.6040 = 60.40 %