In 2011 the Keenan Company paid dividends totaling $2,830,000 on net income of $

Question

In 2011 the Keenan Company paid dividends totaling $2,830,000 on net income of $16 million. Note that 2011 was a normal year and for the past 10 years, earnings have grown at a constant rate of 7%. However, in 2012, earnings are expected to jump to $27.2 million and the firm expects to have profitable investment opportunities of $11.2 million. It is predicted that Keenan will not be able to maintain the 2012 level of earnings growth because the high 2012 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2012, the company will return to its previous 7% growth rate. Keenan's target capital structure is 40% debt and 60% equity.

A. Calculate Keenan's total dividends for 2012 assuming that it follows each of the following policies: (Write out your answers completely. For example, 25 million should be entered as 25,000,000.)

1. Its 2012 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. Round your answer to the nearest cent.
$ _____

2. It continues the 2011 dividend payout ratio. Round your answer to the nearest cent.
$ _____

3. It uses a pure residual dividend policy (40% of the $11.2 million investment is financed with debt and 60% with common equity). Round your answer to the nearest cent.
$ _____

4. 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. Round your answer to the nearest cent.

B. Which of the preceding policies would you recommend?
Select one-Policy 1, Policy 2, Policy 3, or Policy 4

C. Assume that investors expect Keenan to pay total dividends of $7,000,000 in 2012 and to have the dividend grow at 7% after 2012. The stock's total market value is $190 million. What is the company's cost of equity? Round your answer to two decimal places.
_____%

D. What is Keenan's long-run average return on equity? [Hint: g = Retention rate x ROE = (1.0 - Payout rate)(ROE).] Round your answer to two decimal places.
_____%

E. Does a 2012 dividend of $7,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower?
Select one -yes, no it should be lower, or, no it should be higher

Explanation / Answer

A.

1. Dividend in 2011 = $ 2830000

Growth rate in dividend = Growth rate in earnings since dividend payment is set to forrce dividends grow at the long run growth rate in earnings.

Thus, desired annual growth rate in dividends = 7%

Dividend payment in 2012 = 2830000*1.07 = $3028100

2. Dividend payout ratio in 2011 = Dividend / earnings = 2830000 / 16000000 = 17.6875%

Earnings in 2012 = $27200000

Dividend desired to be paid in 2012 = 27200000 * 17.6875% = $4811000

3. Earnings in 2012 = $27200000

    Less:

    Investment              $11200000

    Balance to be

    distributed as dividends $16000000

4. Regular dividend as calculated in 1. above = $3028100

Earnings                                                27200000

Less: Regular Dividend                          3028100

Less: Investment                                  11200000

Balance                                                12971900

Thus, residual dividends = $12971900

B.

The policy-2 of payment of dividend maintaining the payout ratio as in 2011 is recommended.

C.

Ke = D1 / P0 + g

where, Ke is cost of equity

P0 is the price of the company's stock

g is the growth rate

Ke = 7 / 190 + 7 = 10.68%

D.

Payout rate = 7/190*100 = 3.68%

Retention rate = 1-0.0368 = 0.9632

Return on Equity = 10.68%

Long run average return on equity = Retention rate * Return on Equity = 0.9632 * 10.68 = 10.29%

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.