Question

When a firm is deciding how much cash to distribute to stockholders, it should consider two things: (1) The overriding objective is to maximize shareholder value and (2) the firm's cash flows belong to shareholders, so income shouldn't be retained unless management can reinvest those earnings at higher rates of return than shareholders can earn themselves. The

model sets the distribution paid equal to net income minus the amount of retained earnings necessary to finance the firm's optimal capital budget. It can be expressed in equation format as:

Distributions	=	Net income – Retained earnings needed to finance new investments
	=	Net income - [(Target equity ratio)(Total capital budget)]

Because investment opportunities and earnings will vary from year to year, strict adherence to this model would result in fluctuating, unstable distributions. However, investors prefer stable, dependable distributions. Consequently, firms should use this model to help set their long-run target payout ratios, but not as a guide to the payout in any one year.

Quantitative Problem: Lane Industries is considering three independent projects, each of which requires a $1.5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here:

Project H (high risk):	Cost of capital = 12%	IRR = 14%
Project M (medium risk):	Cost of capital = 10%	IRR = 8%
Project L (low risk):	Cost of capital = 7%	IRR = 8%

Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of $4,500,000. If Lane establishes its distributions from the residual distribution model, what will be its payout ratio? Round your answer to two decimal places.
%

Answer 1

Residual Distribution Model for dividends

From the question we have,

Number of projects : 3

Investment per project : $1.5 million

Optimal or target capital sturcture : 60% Common Equity, 40% Debt

Expected Net Income : $4,500,000

From the table given in the question, we observe that the IRR of each of the projects are greater than the Cost of Capital. This means that the company can invest in all three projects.

Hence, in this case, total investments for the year will be:

Total Investments for the year = Number of projects * Investment per project

Total Investments for the year = 3 * 1,500,000 = $4,500,000

Now, the total investments are expected to be funded from equity and debt in the 60:40 ratio. This is nothing but the optimal capital structure for the company.

We apply the following formula in order to arrive at the dollar value of dividend distributions paid by the company:

Dividend Distributions = Net Income - (Target Equity Ratio)*(Total Captial budget)

where

Equity Ratio = Percentage of Equity in the total capital structure of the firm.

Plugging in the values we get,

Dividend Distributions = $4,500,000 - (0.60)*(4,500,000)

Dividend Distributions = $4,500,000 - (0.60)*(4,500,000)

Dividend Distributions = $4,500,000 - $2,700,000

Dividend Distributions = $4,500,000 - $2,700,000

Dividend Distributions = $1,800,000

Now,

Dividend Payout Ratio = Dividend Distributions/Net Income

Dividend Payout Ratio = 1,800,000/4,500,000

Dividend Payout Ratio = 0.40 = 40.00%