Question

The Wagner Company tries to follow a pure "residual" dividend policy. Earnings and dividends last year were $100 million and $20 million respectively. Anticipated earnings for this year are $80 million. The company is financed completely with common equity. The required rate of return on retained earnings is 15 percent and the cost of new equity is 16 percent. If Wagner has $70 million of investment projects having expected returns greater than 15 percent, determine the total amount of dividends Wagner should pay.

Answer 1

Under Residual Dividend Policy, earnings are firstly utilized to carry out investment requirements and whatever residue is left, is paid to shareholders as dividend.

In the given case, residual dividend payment will be calculated as under :-

Anticipated Income = $ 80 Million

Less : Funding required for Investment Projects $ 70 Million

Balance Available $ 10 Million

Therefore, company should pay $ 10 Million only as dividend and utilize $ 70 Million for its investment projects.

Moreover, Investment projects are promising as expected returns which can be generated by these investments are greater than 15%. Even if the shareholders will discourage dividends paid less by $10 Million as compared to last year but in the long run, share value of the company will definitely increase because of increase in earnings from the new projects.

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