Residual dividend policy As president of Young\'s of California, a large clothin

Question

Residual dividend policy As president of Young's of California, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks about the company's dividend policy. In fact, the stockholder has asked you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you P14-3 2 do know the following: (1) The company follows a residual dividend policy. (2) The total capital budget for next year is likely to be one of three amounts depending on the results of capital budgeting studies that are currently un- der way. The capital expenditure amounts are $2 million, $3 million, an $4 million. (3) The forecasted level of potential retained earnings next year is $2 million. (4) The target or optinal capital structure is a debt ratio of 40%. You have decided to respond by sending the stockholder the best information avail- able to you. a. Describe a residual dividend policy. b. Compute the amount of the dividend (or the amount of new common stock needed) and the dividend payout ratio for each of the three capital expenditure amounts c. Compare, contrast, and discuss the amount of dividends (calculated in part b) associated with each of the three capital expenditure amounts.

Explanation / Answer

a) According to Residual dividend policy, the amount of dividend is paid only after all the capital expenditures have been met. Also, one has to keep in mind that capital strucure has to be maintained while following this policy.

b)

All values are in million dollars We have caclulated the debt and equity ratio. Whatever the amount of equity has been calculated would have to be substracted from $2 million of retained earnings. Any positive remaining amount shall be paid out as dividends. If the amount is negative this means that new equity is being issued.

c) When capital expenditure is 2 million the equity share is 1.2 hence 0.8 is left out that is paid as dividends. In case of 3 million, the equity share for expenditure increases, thereby leading to a lesser dividend payout of 0.20 million. When the equity is more than retained earnings, it means that new equity is to be issued as in the case of $4 million capex.

Capital expenditure Debt(40%) Equity Dividend New equity issued $                             2.00 $       0.80 $       1.20 $       0.80 $           -   $                             3.00 $       1.20 $       1.80 $       0.20 $           -   $                             4.00 $       1.60 $       2.40 $ 0.40

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