Question

Kendra Brown is analyzing the capital requirements for Reynold Corporation for next year. Kendra forecasts that Reynold will need $14 million to fund all of its positive-NPV projects, and her job is to determine how to raise the money. Reynold's net income is $8 million, and it has paid a $3 dividend per share (DPS) for the past several years (2.0 million shares of common stock are outstanding); its shareholders expect the dividend to remain constant for the next several years. The company's target capital structure is 50% debt and 50% equity.

1. Suppose Reynold follows the residual model and makes all distributions as dividends. How much retained earnings will it need to fund its capital budget? Round your answer to the nearest dollar.
   $  
   
2. If Reynold follows the residual model with all distributions in the form of dividends, what will be its dividend per share? Round your answer to the nearest cent.
   $  
   
   What will be its payout ratio for the upcoming year? Round your answer to two decimal places.
        %
   
3. If Reynold maintains its current $3 DPS for next year, how much retained earnings will be available for the firm's capital budget? Round your answer to the nearest dollar.
   $  
   
4. Can Reynold maintain its current capital structure, maintain its current dividend per share, and maintain a $14 million capital budget without having to raise new common stock?
       

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• Suppose management is firmly opposed to cutting the dividend; that is, it wishes to maintain the $3 dividend for the next year. Suppose also that the company is committed to funding all profitable projects and is willing to issue more debt (along with the available retained earnings) to help finance the company's capital budget. Assume the resulting change in capital structure has a minimal impact on the company's composite cost of capital, so that the capital budget remains at $14 million. What portion of this year's capital budget would have to be financed with debt? Round your answer to two decimal places.
       %
  
• Suppose once again that management wants to maintain the $3 DPS. In addition, the company wants to maintain its target capital structure (50% debt, 50% equity) and its $14 million capital budget. What is the minimum dollar amount of new common stock the company would have to issue in order to meet all of its objectives? Round your answer to the nearest dollar.
  $  
  
• Now consider the case in which management wants to maintain the $3 DPS and its target capital structure but also wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming the company's projects are divisible, what will be the company's capital budget for the next year? Round your answer to the nearest dollar.
  $  
  
• If a firm follows the residual distribution policy, what actions can it take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?

Answer 1

(a) Residual Dividend Policy
Capital Budget				14	million
Capital structure is 50% equity
Equity portion = 14 million * 50% =				7	million
So, company will need $7,000,000 retained earnings to fund its capital budget.
(b)
Net income this Year				8	million
Residual dividend = Net income - Project portion financed by equity
		8	-7	1	million
No. of shares outstanding				2	million
So, dividend per share 1/2 million =				$       0.50
Dividend per share will be $0.50
Payout ratio = Dividend/Net income
	1000000/8000000
	0.125	or 12.5%
So, Payout ratio shall be 12.5%
(c )
Net income this Year				8	million
Less : Dividend paid (3 * 2million)				6	million
				__________
				2	million
So, Reynold will have $2,000,000 retained earnings for the capital budget.
(d ) If company maintains current capital structure of 50%, then dividend payout ratio shall be 12.5% while current payout ratio is 37.5%. If it maintains current dividend payout ratio, then retained earnings of $7,000,000 shall not be available for $14,000,000 capital budget.
So, Company cannot maintain its current capital structure, current dividend per share and maintain $14,000,000 capital budget without having to raise new common stock.