Question

Problem 14-11 Residual Distribution Model Kendra Brown is analyzing the capital requirements for Reynold Corporation for next year. Kendra forecasts that Reynold will need $6 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 $6 million, and it has paid a $2.00 dividend per share (DPS) for the past several years (1.0 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 30% debt and 70% equity. 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. $ 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 payout ratio for the upcoming year? Round your answer to two decimal places.      % If Reynold maintains its current $2.00 DPS for next year, how much retained earnings will be available for the firm's capital budget? Round your answer to the nearest dollar. $ Can Reynold maintain its current capital structure, maintain its current dividend per share, and maintain a $6 million capital budget without having to raise new common stock?     -Select-NoYesItem 5 Suppose that Reynold's management is firmly opposed to cutting the dividend; that is, it wishes to maintain the $2.00 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 $6 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 Reynold's management wants to maintain the $2.00 DPS. In addition, the company wants to maintain its target capital structure (30% debt, 70% equity) and its $6 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 $2.00 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?     -Select-Declare a stock dividend.Issue new common stock.Change capital structure, that is, use less debt.Increase its capital budget.Increase dividends.Item 9

Answer 1

Capital budget = 6 million; Net income = 6 million; Debt ratio = 30%; Equity ratio = 70%; DPS = $2; Number of shares = 1 million

a). retained earnings needed = capital budget*equity ratio = 6 million*70% = 4.2 million or 4,200,000

b). Residual amount left after retained earnings = net income - retained earnings = 6 million - 4.2 million = 1.8 million

DPS = 1.8 million/1 million shares = $1.80 per share

Payout ratio = Dividends paid/Net income = 1.8/6 = 30.00%

c). If DPS = $2 then total dividends = 2*1 million = 2 million

Retained earnings = Net income - Dividends = 6 million - 2 million = 4 million or 4,000,000

d). No. It will have to raise new common stock because in order to maintain its current capital structure, it needs to retain 4.2 million of the net income (part a) but if its DPS is $2 per share then it will retain only 4 million (part c). There is a shortfall of 0.2 million.

e). Capital budget = 6 million; DPS = $2 per share so total dividends = 2 million.

Retained earnings = 6 - 2 = 4 million.

So, portion of debt = (6-4)/6 = 2/6 = 33.33%

f). To maintain 70% equity in the capital budget, total equity required = 70%*6 = 4.2 million

Retained earnings left after paying dividends of $2 per share = 4 million

So, minimum dollar amount of new common stock = 4.2 million - 4 million = 0.2 million or 200,000

g). If no new common stock is to be issued then retained earnings will have to be equal to the total equity requirement of the capital structure which is 70%.

Retained earnings after $2 per share of DPS = 4 million

Capital budget = 4/70% = 5,714,286

h). It can issue new common stock if its forecasted retained earnings are less than the required retained earnings.