14-9 ALTERNATIVE DIVIDEND POLICIES In 2008, Keenan Company paid dividends totali

Question

14-9      ALTERNATIVE DIVIDEND POLICIES In 2008, Keenan Company paid dividends totaling

$3,600,000 on net income of $10.8 million. Note that 2008 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2009, earnings are expected to jump to $14.4 million, and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that Keenan will not be able to maintain the 2009 level of earnings growth—the high 2009 earnings level is attributable to an exceptionally profitable new product line introduced that year—and the company will return to its previous 10% growth rate. Keenan’s target capital structure is 40% debt and 60% equity.

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b.       Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer.

c.        Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2009 and to have the dividend grow at 10% after 2009. The stock’s total market value is $180 million. What is the company’s cost of equity?

d.       What is Keenan’s long-run average return on equity? [Hint: g = Retention rate X

ROE = (1.0 - Payout rate)(ROE).]

e.        Does a 2009 dividend of $9,000,000 seem reasonable in view of your answers to Parts c and d? If not, should the dividend be higher or lower? Explain your answer.

Explanation / Answer

b. I would recommend the company to continue with constant grwoth model of dividends ignoring the exception of high income for 2009. This excess earnings could be used for future growth opportunities.

However, we do not have the preceding policies to choose the best among them,

c. The cost of equity = D1/P0 + g

D1 = dividend next year = D0 *(1=g) = 9,000,000*(1+0.10) = 9,900,000 = 9.9 Million

Current market Value = P0 = 180 million

g = 10% = 0.10

Cost of equity = 9.9/180 + 0.10 = 0.155 = 15.5%

d. ROE = g * Retention ratio

g = 0.10

Dividend paid in 2009 is 9 Million

Total earning was 14.4 Million

So amount retained = 14.4 - 9 = 5.4 Million

Retention ratio = 5.4/14.4 = 0.375

Hence Return on equity (ROE) = 0.10 *0.375 = 0.0375 = 3.75%

e. No. The 2009 dividend of 9,000,000( 9 million) is unreasonable. The dividend should be much lower. In part "c" the cost of equity is exceptionally high and in part "d" the return on equity is very low thereby showing mismatch.

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