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 $2.2 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 = 16% IRR = 18% Project M (medium risk): Cost of capital = 8% IRR = 6% Project L (low risk): Cost of capital = 11% IRR = 12% 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 $3,000,000.

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