15-10 Buena Terra Corporation is reviewing its capital budget for RESIDUAL DIVID
ID: 2515664 • Letter: 1
Question
15-10 Buena Terra Corporation is reviewing its capital budget for RESIDUAL DIVIDEND MODEL the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The company's target capital structure is 60% equity and 40% debt, it has 1,000,000 shares of common equity outstanding, and its net income is $8 million. The company forecasts that it will require $10 million to fund all of its profitable (i.e., positive NPV) projects for the upcoming year.Explanation / Answer
a) If the firm follows the residual dividend model, it will first pay for its capital expenditures and then pay any residual earnings as dividend. The capital expenditure required is $10 million, and the net income is $8 million, so it will need all of its $8 million retained earnings to fund the capital expenditure.
b) If the firm follows the residual dividend model, no dividends will be paid in the coming year as all the earnings will be retained and used for funding the capital expenditures. Hence, the dividend per share will be 0 and the payout ratio will also be 0.
c) If the firm pays dividend of $3 per share, total dividends paid next year = 3*1000000 = $3 million. Therefore the retained earnings after paying dividends would be $8 million - $3 miilion = $5 million. Hence, $5 million will be available for paying for capital expenditures.
d) No, the company cannnot maintian its present capital strucure, $3 DPS and $10 million capital expenditure without issuing new stock. It can either raise new stock or raise additional debt, both of which will lead to a change in the capital structure.
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