Residual dividend model Welch Company is considering three independent projects,

Question

Residual dividend model

Welch Company is considering three independent projects, each of which requires a $4 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects is presented below:

Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 30% debt and 70% common equity, and it expects to have net income of $9,420,500. If Welch establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places.

%

Project H (High risk): Cost of capital = 16% IRR = 21% Project M (Medium risk): Cost of capital = 12% IRR = 11% Project L (Low risk): Cost of capital = 8% IRR = 10%

Explanation / Answer

Expected net income =$9,420,500

Amount required for the projects = $4,000,000

Number of projects =3

Total investment required =$4,000,000 *3 =$12,000,000

As the company wants to maintain a debt equity ratio of 30% debt and 70% equity.

The projects requires own funds 70% =$12,000,000*70% =8,400,000.

The remaining funds are to be financed from debt =$3,600,000.

Dividends paid = Net income - funds required for funding new projects = $9,420,500 - $8,400,000=$1,020,500

Pay out ratio =(Dividends paid/Net earnings for the period) * 100

=($1,020,500/9,420,500) *100

=10.83275% rounded to 10.83%

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