New product expansion with 15 million investment in new machinery. Using current

Question

New product expansion with 15 million investment in new machinery. Using current 30% debt to total assets ratio for capital structure to maintain dividend policy of annual distribution 25% of net income. The net income is 8 million. How much external equity needed to expand? Residual distribution model New product expansion with 15 million investment in new machinery. Using current 30% debt to total assets ratio for capital structure to maintain dividend policy of annual distribution 25% of net income. The net income is 8 million. How much external equity needed to expand? Residual distribution model

Explanation / Answer

External equity (amount of finance to be raised through outside equity for meeting investment requirements) to can be calculated with the use of following steps.

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Step 1: Calculate the value of Retained Earnings:

Retained Earnings = Net Income*(1-Dividend Payout Ratio), where Net Income is 8 million and dividend payout ratio is 25%.

Retained Earnings = 8,000,000*(1-25%) = $6,000,000

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Step 2: Calculate Total Equity Required:

Total Equity Required = Expected Investment*(1-Debt to Total Assets Ratio), where expected investment is $15,000,000 and Debt to Total Assets Ratio = 30%

Tota Equity Required = 15,000,000*(1-30%) = $4,500,000

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Step 2: Calculate External Equity:

External Equity = Total Equity Required - Retained Earnings = 6,000,000 - 4,500,000 = $1,500,000

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