Farm Co. Inc. follows a policy of paying out cash dividends equal to the residua

Question

Farm Co. Inc. follows a policy of paying out cash dividends equal to the residual amount that remains after funding 60% of its planned capital expenditures. The firm tries to maintain a 40% debt and 60% equity capital structure and does not plan on issuing more stock in the coming year. The CFO has estimated that the firm will earn $12 million in the current year. a) If the firm maintains its target financing mix and does not issue any equity next year, what is the most it could spend on capital expenditures next year given its earning estimate? b) If Farmco's capital budget for next year is $10 million, how much will the firm pay in dividends and what is the resulting dividend payout percentage? Answer A is: $_______________ million (Round 2 decimal places) Answer B is: _______ %

Explanation / Answer

Part A

Cash dividend = 60 % capital expenditure

Retained earnings = 12 million x 0.60

Capital expenditure = 0.40 x Debt + 0.60 Equity

                                CE       = 0.40 x CE + (12 million – 0.60 CE)

                               CE =    12million – 0.20 CE

                                CE = 10 million

Part A

Dividend = 60% x CE

                = 60% x 10 million

                   = 6 million

Dividend payout = dividend / total income

                                = 6 million/ 12 million

                                = 50%

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