Question

Norman Inc. wishes to accept a new project which has a NPV of US$98,000. A sum of US$10,000,000 will be needed to invest in it. The net earnings for the current year are US$1,000,000 and the accumulated retained earnings to date are US$7,000,000. The current amount of long term debt carried on Norman Inc.’s balance sheet is US$5,333,333.33. Norman Inc. wishes to finance the new investments in line with its existing capital structure.
i. Will Norman Inc. be in a position to pay any dividends this year if it follows the residual dividend approach? If yes, what will be the total amount of dividend paid?
ii. What will be the debt‐to‐equity ratio of the newly financed project?
iii. What would be the implications of Norman Inc.’s dividend payout decision?

Answer 1

	Total retained earnings = 7000000+1000000 =	$       80,00,000
	Long term debt	$       53,33,333
	Total	$   1,33,33,333
	Weight of long term debt = 5333333/13333333 =	40.00%
	Weight of equity = 8000000/13333333 =	60.00%
i)	The required equity for the new investment = 10000000*60% =	$       60,00,000
	As the total retained earnings is 8000000, the equity
	portion can be met out of it.
	Residual amount that can be paid as dividend = 8000000-6000000 =	$       20,00,000
	Answer:
	Yes.
	Total amount of dividend that can be paid =	$       20,00,000
ii)	Debt equity ratio for the newly financed project = 0.40/0.60 =	0.67
iii)	The residual dividend policy would mean that, the
	dividends would fluctuate from year to year
	depending on the retained earnings available for
	distribution after providing for the equity portion of
	capital expenditure. Fluctuating dividends will drive
	away investors who required constant or growing
	dividends.