Problem II Boehm Corporation has had stable earnings growth of 8%. a year for th

Question

Problem II Boehm Corporation has had stable earnings growth of 8%. a year for the past 10 years, and in 2013 Boehm paid dividends of $2.6 million on net income of $9.8 million. However, in 2014 earnings are expected to jump to $12.6 million, and Boehm plans to invest $7.3 million in a plant expansion. This one-time unusual earnings growth won't be maintained though. and after 2014 Boehm will return to its previous 8% earnings growth rate. Its target debt ratio is 35%. ... Calculate Boehm's total dividends for 2014 under each of the following policies: Its 2014 dividend payment is set to force dividends to grow at the long -run growth rate in earnings. It continues the 2013 dividend payout ratio It uses pure residual policy with all distributions in the form of dividends (35% of the $7.3 million is financed with debt). It employs a regular -dividend -plus -extras policy, with the regular dividend being based on the long run growth rate and the extra dividend being set according to the residual policy. t Which of the preceding policies would you recommend? Restrict your choice to the ones listed but justify your answer. Does a 2014 dividend of $9 million seem reasonable in view of your answers to pans (a) and (b)? If not. should the dividend be higher or lower?

Explanation / Answer

a)

1) Logn-term growth rate is 8% and the dividends tend to grow at this rate. Total dividends would be:

2014 Dividends = 2013 Dividends X 1.08

                          = $2.6 million X 1.08 = $2.808 million

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2) If the 2013 payout ratio is continued, then the total dividends would be:

2014 Dividends = 2014 Earnings X (2013 Dividends / 2013 Earnings)

                         = $12.6 million X ($2.6 million / $9.8 million)

                         = $3.34 million

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3) According to residual dividends policy, the dividends are paid out only after making all the distributions and provisions.

Distribution = Net income - (Target equity ratio X Capital budget)

                   = $12.6 million - ( 0.65 X $7.3 million)

                   = $7.855 million

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4) The regular dividend is $2.808 million calculated in part-1 and the dividend according to residual dividend is $7.855 calculated in part-3. Therefore, the extra dividend is

Extra dividend = $7.855 million - $2.808 million

                        = $5.047 million

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b) The policy of regular dividend plus extra dividend is the most appropriate choice. If it is implemented properly, it may lead to sufficient capital budget and shows the right signal to investors.

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c) As per our answer in a and b, the dividend of $9 million is on higher side. Hence, the dividend should be lower than $9 million.

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