Question

Walsh Company is considering three independent projects, each of which requires a $4 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here:

Project H (high risk):	Cost of capital = 15%	IRR = 22%
Project M (medium risk):	Cost of capital = 11%	IRR = 13%
Project L (low risk):	Cost of capital = 7%	IRR = 8%

Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 35% debt and 65% common equity, and it expects to have net income of $14,215,500. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places.

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Answer 1

The company is considering three individual projects with varied risks i.e. high risk, medium risk and low risk.

It wants to know the the payout ratio in case of each of the projects based on residual dividend model. In case of residual dividend model cost of equity and IRR are irrelevant.

Company's desired capital structure is 35% Debt and 65% Equity.

Residual dividend is calculated as follow -

Residual Dividend = Net Income - (Target Equity Ratio X Total capital Investment required)

Payout Ratio = Dividend Paid / Total capital Investment

Accordingly, total capital investment required for three projects amount to $4 million X 3 = $12 million.

Expected Net Income = $14,215,500

Dividend = $14,215,500 - ( 65% X 12 million)

= $6,415,500

Payout ratio = $6,415,500 / %12,000,000

= 53%