Question

West global sdn bhd has a capital budget of $2,000,000.00. the company wants to maintain a target capital structure that consists of 40% equity and 60% debt. the company forecasts that its net income this year will be $1,200,000.00 and there are 500,000 common stocks outstanding.

a. If the company follows a residual dividend policy, what will be the dividend payout ratio and its dividend per share?

b. Suppose West Global follows a constant dividend payout ratio of 40%, does it require external financing to fund the equity portion of its capital budget? Please show your computation to substantiate your answer.

Answer 1

(a) Residual Dividend Policy
Capital Budget				2000000
Capital structure is 60% equity
Equity portion = 2000000*60% =				1200000
Net income this Year				1200000
Residual dividend = Net income - Project portion financed by equity
		1200000	-1200000	0
So, if company follows a residual dividend policy, Dividend payout ratio and dividend per share shall be 0.
(b)
Net income this Year				1200000
Dividend payout ratio is 40%
So, Dividend paid (1200000*40%) =				-480000
Retained earnings				720000
Retained earnings 720,000 shall be used to finance the project.
Capital Budget				2000000
Capital structure is 60% equity
Equity portion = 2000000*60% =				1200000
Equity portion				1200000
Less : Retained earnings				-720000
External financing required.				480000
Equity portion of capital budget is $1,200,000. Retained earnings of $720,000 shall be used.
Remaining $480,000 external financing shall be required to finance the equity portion.