Question

The Wei Corporation expects next year's net income to be $ 15 million. The firm's debt ratio is currently 40%. Wei has $ 12 million of profitable investment opportunities, and it wishes to maintain its existing debt ratio. According to the residual model ( assuming all payments are in the form of dividends), how large should Wei's dividend payout ratio be next year?

Answer 1

Solution :

Calculation of Residual Dividend :

The formula for calculating the Residual dividend is

Residual Dividend = Net Income – ( Target Equity Ratio * Capital Investment )

As per the information given in the question we have

Net Income = $ 15 million ; Capital Investment = $ 12 million

Target Debt Ratio = 40 % = 0.40 ;

We know that target equity ratio = ( 1 – Target Debt Ratio )

= 1 – 0.40 = 0.60 = 60 %

Thus Target Equity Ratio = 0.6= 60 %

Applying the above information in the formula we have Residual Dividend as

= $ 15 million - ( 60 % * $ 12 million )

= $ 15 million - $ 7.2 million

= $ 7.8 million

Thus Residual Dividend payable = $ 7.8 million

Calculation of Dividend Payout ratio:

The formula for calculating the Dividend Payout Ratio is

= Residual Dividend / Net Income

As per the information available we have

Residual Dividend = $ 7.8 million ; Net Income = $ 15 million ;

Applying the above information in the formula we have Dividend Payout ratio as :

= $ 7.8 million / $ 15 million

= 0.5200

= 52 %

Thus Wei's dividend payout ratio next year = 52 %