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:

Project H (High risk):

Cost of capital = 17%

IRR = 20%

Project M (Medium risk):

Cost of capital = 15%

IRR = 11%

Project L (Low risk):

Cost of capital = 8%

IRR = 9%

Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 45% debt and 55% common equity, and it expects to have net income of $12,682,000. 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 = 17%

IRR = 20%

Project M (Medium risk):

Cost of capital = 15%

IRR = 11%

Project L (Low risk):

Cost of capital = 8%

IRR = 9%

Explanation / Answer

here project medium should not be accepted since IRR 11% is lower than cost of capital 15%, and rest of the project should be accepted hence total capital budget is needed 4*2=8 million,

now since we know that equity 55% of 8 million should be equity = 4.4 million

Divided = Net income - Required equity

=12,682,000-4400000=8282000

8282000/12682000=65.31% Payout ratio.

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