Question 3. (15 points) Pierre Imports has a capital budget of $20 million. It w

Question

Question 3. (15 points) Pierre Imports has a capital budget of $20 million. It wants to maintain a capital structure of 45 percent debt and 55 percent equity. This year it expects net income of $8 million. The company has 30 million authorized shares, and 10 million are outstanding. Last year the company paid a dividend of $0.30 per share.

a. How much equity is required?

b. How much external equity does the company need to raise if it follows a residual dividend policy?

c. How much external equity will the company require if it pays the same dividend as last year?

d. What are 3 advantages of following a residual dividend policy?

e. What are 3 disadvantages of following a residual dividend policy?

Explanation / Answer

Since, there are multiple parts, the first four have been answered.

_____________

Part A)

The value of equity required can be calculated with the use of following formula:

Value of Equity = Total Capital Budget*Estimated Proportion of Equity in the Capital Structure

Using the values provided in the question, we get,

Value of Equity = 20,000,0000*55% = $11,000,000

_______

Part B)

The value of external equity needed is calculated as follows:

Value of External Equity Needed = Value of Equity (as Calculated in Part 1) - (Net Income - Retained Earnings) where Retained Earnings = Net Income*Proportion of Equity

Using the information provided in the question, we get,

Value of External Equity Needed = 11,000,000 - (8,000,000 - 55%*8,000,000) = $7,600,000

_______

Part C)

The value of external equity needed is calculated as follows:

Value of External Equity Needed = Value of Equity (as Calculated in Part 1) - (Net Income - Dividends) where Dividends = Common Shares Outstanding*Dividend Per Share

Using the information provided in the question, we get,

Value of External Equity Needed = 11,000,000 - (8,000,0000 - 10,000,000*.30) = $6,000,000

_______

Part D)

The three advantages associated with a residual dividend policy include:

a) It focuses on the use of internal equity, that is retained earnings, resulting in lower cost of capital for the company.

b) Another advantage of residual dividend policy is that it reduces the need/frequency for/of the issuance of new equity.

c) The final advantage of residual dividend policy is that the flotation costs and complexities associated with the issuance of new equity can be avoided.

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