Question

Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose, each of which requires a $ 3 million investment. These projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and costs of capital are as follows:

Project A:       Cost of capital = 17%; IRR = 20%

Project B:       Cost of capital = 13%; IRR = 10%

Project C:       Cost of capital = 7%; IRR = 9%

Harris intends to maintain its 35% debt and 65% common equity capital structure, and its net income is expected to be $ 4, 750,000. If Harris maintains its residual dividend policy ( with all distributions in the form of dividends), what will its payout ratio be?

Answer 1

Expected Dividend Pay-out Ratio using residual dividend model

Step-1, Determination of total Investment cost by comparing the Project’s IRR with their cost of capital

We know that the project should be accepted only if the IRR is greater than the cost of capital. Here, the IRR for the Project A and Project C are greater than their cost of capital and therefore, the Project A and Project C should be accepted.

Hence, the total Investment cost will be $6,000,000 [$3,000,000 x 2]

Step-2, Calculation of Total Dividend paid

Total Dividend paid using the residual dividend policy is calculated as follows

Total Dividend = Net Income – [Total Capital Budget x Equity Ratio]

= $4,750,000 – [$6,000,000 x 65%]

= $4,750,000 - $3,900,000

= $850,000

Step-3, The Expected Dividend Pay-out Ratio for this year

Therefore, the Expected Dividend Pay-out Ratio = [Total Dividend Paid / Net Income] x 100

= [$850,000 / $4,750,000] x 100

= 17.89%

“Hence, the Expected Dividend Pay-out Ratio will be 17.89%”