Question

In 2005, Keenan Company paid dividends totaling $ 3,600,000 over a net profit of $ 10.8 million. It was a normal year and in the last 10 years, profits grew at a constant rate of 10%. But in 2006 it is expected to reach $ 14.4 million and that there are profitable investment opportunities for $ 8.4 million. It is anticipated that Keenan will not be able to maintain that level of growth - attributed to a new line of exceptionally profitable products that it introduced - and that the previous 10% growth rate will resume. The optimal debt ratio is 40 percent.

to. Calculate the total dividends in 2006, if you observe the following policies:

1) The 2006 dividend payment is established to make them grow at the same rate as that of profits.

2) The payment reason for 2005 continues.

3) A pure residual policy is applied, with all distributions through dividends (40% of the $ 8.4 million invested are financed with debt).

4) A policy of regular dividends plus extras is applied, in which dividends are based on the long-term growth rate and the extras are set in accordance with the residual policy.

b. Which of the above policies would you recommend? Limit your options to those included here and substantiate your response.

c. Does a dividend of $ 9,000,000 in 2006 seem reasonable in view of the responses to parts a and b? If not, should the dividend be higher or lower?

Answer 1

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1. Dividend paid in 2005 = $3,600,000

Growth rate in dividend = Growth rate of profits = 10%

Dividend payment for 2006 = $3,600,000 * 1.1 = $3,960,000

2. Dividend payout ratio in 2005 = Dividend paid in 2005 / Earnings of 2005

= $3,600,000 / $10,800,000 = 0.3333 or 33.33%

Earnings of 2006 = $14,400,000

Dividend desired in 2006 = Earnings of 2006 * Dividend payout ratio in 2005

= $14,400,000 * 33.33% = $4,800,000

3. Earnings of 2006 = $14,400,000

Investment = $8,400,000

Amount to be distributed as dividend = Earnings of 2006 - Investment

= $14,400,000 - $8,400,000

= $6,000,000

4. Dividend as calculated in Part 1 = $3,960,000

Earnings of 2006 = $14,400,000

Investment = $8,400,000

Amount to be distributed as dividend = Earnings of 2006 - Investment - Dividend as calculated in Part 1

= $14,400,000 - $8,400,000 - $3,960,000

= $2,040,000

b. Policy 3 is recommended as it pays the highest dividend.

c. The dividend of $9,000,000 is not reasonable as per policy 3. The amount of dividend should be lower than $6,000,000.