4. The residual dividend model Aa Aa The residual dividend policy approach to di
ID: 2784510 • Letter: 4
Question
4. The residual dividend model Aa Aa The residual dividend policy approach to dividend policy is based on the theory that a firm's optimal dividend distribution policy is a function of the firm's target capital structure, the investment opportunities available to the firm, and the availability and cost of external capital. The firm makes distributions based on the residual earnings. Consider the case of Yellow Duck Distribution Company: Yellow Duck Distribution Company has generated earnings of $140,000,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $85,000,000 on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure. The company makes distributions in the form of dividends 60% 40% Equity Debt What will Yellow Duck Distribution's dividend payout ratio be if it follows a residual dividend policy? O O O 54.04% 38.14% 63.57% 57.21%Explanation / Answer
Residual dividend policy is type of dividend policy in which first company use its earnings for the capital investment in current. The amount remained after fulfill all the obligation of capital investment, pays to shareholder as dividend.
Total Income = $140,000,000
Capital Spending = $85,000,000
Weight of debt in capital project is 40% and weight of equity is 60%.
Total Equity required for new project = $85,000,000 × 60%
= $51,000,000
Total Equity required for new project is $51,000,000.
Amount remained for dividend = $140,000,000 - $51,000,000
= $89,000,000
Payout ratio = $89,000,000 / $140,000,000
= 63.57%
Payout ratio next year will be 63.57%.
Option (C) is correct answer.
b.
if company increase debt ratio, then Total Equity required for new project will be lesser. So more amount from earnings remains for dividend payment, so payout ratio will increase.
c.
Earnigs of firm would be more stable than dividend of comapny. Dividend of comapny depends on availability of project.
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