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 $5 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 $12,494,000. 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 = 15% IRR = 19% Project M (Medium risk): Cost of capital = 13% IRR = 11% Project L (Low risk): Cost of capital = 8% IRR = 10%

Explanation / Answer

Capital budget should be $10 million. We know that 70% of the $10 million should be equity. Therefore, the company should pay dividends of:

   Dividends = Net income - needed equity

= $ 12,494,000 - $7,000,000 = $ 5,494,000.

Payout ratio = $ 5494000/$12,494,000 = 0.4397 = 43.97%.

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