14-9 Residual Distribution Policy--Second time posting! The answer has been prov

Question

14-9 Residual Distribution Policy--Second time posting!

The answer has been provided. It is 17.89%. The supporting work and formulas must be provided to support answers. This is being submitted a second time as the first time the work provided supported a wrong answer.

Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose each of which requires a $3 million capital. These projects have different levels of risk and therefore different costs of capital. The projected IRRs and costs of capital are as follows:

Project A             Cost of Capital = 17%; IBR = 20%

Project B             Cost of Capital = 13%; IBR = 10%

Project C             Cost of Capital = 7%; IBR = 9%

Harris intends to maintain its 35% debt and 65% common equity capital structure and its net income is expected to be $4,750,00. If Harris maintains its residual dividend policy (with all distributions in the form of divedends) what will its payout ratio be? (Answer is 17.89%--Show all work and formula to support answer.)

Explanation / Answer

Under residual dividend policy companies uses internally generated equity to finance new projects andincome remaining after financing the project is distributed as dividend. In the given question the capital structure of the company is 35% of debt and 65% of equity.Thus in order to finance a project the company will borrow 35% of the cost of the project and remaining wiil be finanaced through equity.

From the given projects company should choose project A and C since in both the projects IRR is more than cost of capital unlike project B.

Thus total Amount to be invested = $6000000

Amount to be borrowed = 6000000 x 35% = 2100000

remainig amount to be financed through equity = 6000000-2100000 = 3900000

Total available income = 4750000

Income to be used in financing the project = 3900000

residual income available for distribution = 4750000 - 3900000 = 850000

Thus, dividend pay out ratio = 850000/4750000 = 17.89%

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