DeAngelo Corp.\'s projected net income is $150.0 million, its target capital str

Question

DeAngelo Corp.'s projected net income is $150.0 million, its target capital structure is 25% debt and 75% equity, and its target payout ratio is 65%. DeAngelo has more positive NPV projects than it can finance without issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable future. The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy. Versus the current policy, how much larger could the capital budget be if (1) the target debt ratio were raised to 75%, other things held constant, (2) the target payout ratio were lowered to 20%, other things held constant, and (3) the debt ratio and payout were both changed by the indicated amounts.
Increase in Capital Budget
Increase Debt to 75% Lower Payout to 20% Do Both

(please show how you arrived at answer)

Explanation / Answer

Answer:

In the given question there is no information about value of total capital and cost of debt capital. Therefore, I am solving the given question with following assumptions;

Let us assume that the total capital of the business is $ 200,000,000 which under current policy consist of 25% debt that is $ 50,000,000 and 75% equity that is $ 150,000,000; and

let us assume that the cost of debt capital is 12% per annum, then;

1 If the target debt ratio is raised to 75%, that means equity 25% and debt 75%;

Conclusion: From the above calculations we see that due to increase in debt content in the capital structure of the business the fixed cost towards financing of debt capital has also increase. This is known as financial leverage effect or capital gearing effect. The increase in debt resulted in decrease in overall investable funds of the business from $ 252,500,000 to $ 248,300,000. In this case the Earning Per Rupee of Share Capital of $ 1.79.

2 If the target payout ratio are lowered to 20%

Conclusion: From the above calculation we find that due to reduction in payout ratio the Company has managed to substantially increase its Investable Amount from $ 252,500,000 to $ 320,000,000. This is so because the company has distributed less and retained more funds with it. However, this is possible only when the company is capable of earning more by investing its retained funds in higher profitable projects. Otherwise the shareholders will not consent to decrease in payout ratio. In this case the Earning Per Rupee of Share Capital of $ 0.20.

3. If debt ratio is increase to 75% and payout ratio is lowered to 20%

Conclusion: From the above calculations we find that the Company is able to manage an increase in its Investable Funds from $ 252,500,000 to $ 310,400,000. In this case since the equity holders own a comparitively lesser portion of capital funds they will have less to say about the decrease in the payout ratio. Also, since after paying fixed cost of debt capital the Company has enough to distribute to equity shareholders that is an Earning Per Rupee of Share Capital of $ 0.55.

Particulars Amount (Current Policy) Amount (New Policy) Equity Capital $150,000,000 $ 50,000,000 Debt Capital $ 50,000,000 $ 150,000,000 Income before interest (assumed) $ 156,000,000 $ 156,000,000 Cost of Debt Capital $ 6,000,000 $ 18,000,000 Net Income after interest $ 150,000,000 $ 138,000,000 Pay Out @ 65% $ 97,500,000 $ 89,700,000 Retained Earnings $ 52,500,000 $ 48,300,000 Investable Amount (Total Capital plus Retained Earnings) $ 252,500,000 $ 248,300,000

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