Question

Assume that in 2017, The Shallonz Corporation reported net income of $143 million, and paid dividends totaling $36.5 million throughout the year. Their net income has been growing at about 5% per year for some time, but it is expected to grow by 20% in 2018. Growth is expected to return to the normal 5% the following year and thereafter. It has also been estimated that the company will need about $52 million in funds for capital expenditures in 2018. The company is financed with 70% equity. What will be the company’s payout ratio if it follows a pure residual dividend policy in 2018? What would the payout ratio be if instead they allowed the dividends to grow at the same rate as the long-term growth rate in income? What would you recommend they do? Please explain exactly why.

Answer 1

Calculation of payout ratio if Shallonz Corporation follows a pure residual dividend policy:

Residual dividend policy is dividend is distributed to it's shareholders after taking into consideration all the funding,investing decisions. It means whatever is left after taking all this capital expenditure, it will be distributed as dividend. Dividend is residual decision under this policy.

Given information,

Net Income of 2017= $143 million

Dividend paid during 2017= $36.5 million

Growth rate of net income for 2018= 20%

I.e. Net income of 2018= $143 million + 20% of $143 million

= $143 million + $28.6 million

= $ 171.6 million.

Capital Expenditure in 2018= $52 million

a) If company bother about capital structure as 70% equity:

Company is financed by 70% equity.

Therefore, from net income of $171.6 million capital expenditure of $ 52 million is reduced and the remaining amount as ($171.6 million - $ 52 million)= $119.6 million is dividend.

But out of this only 70% will be considered as dividend because company is financed by only 70% equity.

Dividend = $ 119.6 million * 70% =$ 83.72 million

Payout ratio = Dividend

Net Income

= $ 83.72 million / $ 171.6 million

= 48.7879%

b) If company does not bother about it's capital structure:

If company does not maintain it's capital structure, the whole amount of $ 119.6 million will be treated as dividend.

Therefore, Payout ratio = $ 119.6 million / $ 171.6 million

= 69.6970%

b)

Calculation of payout ratio if they allowed the dividend to grow at the same rate as that of long term growth rate in income:

As the growth rate in income is 20% for 2018, but long term growth rate is 5% for following years.

Therefore if dividend is growing by this rate, company's dividend will be

dividend= Last year's dividend + growth rate

= $ 36.5 million + 5%

= $ 38.325 million

Payout ratio = $38.325 million / $171.6 million

= 22.3339%

c)

Recommendation:

If company pays dividend by residual policy, shareholders will get sometimes more but sometimes less dividend. It shows that dividends of company are fluctuating so shareholders think that company is risky and they starts to expect the higher return.

In case of growing rates of dividend, company pays moderate dividend.

Shallonz Corporation should accept the dividend to grow at same rate as that of growth rate in income as income increase accordingly dividend increases rather than accepting residual approach.