Question

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 Purple Hedgehog Forestry Group: Purple Hedgehog Forestry Group is expected to generate $240,000,000 in net income over the next year. Purple Hedgehog Forestry has forecasted a capital budget of $88,000,000, and it wishes to maintain its current capital structure of 70% debt and 30% equity. 30% Equity 70% Debt If the company follows a strict residual dividend policy and makes distributions in the form of dividends, what is its expected dividend payout ratio for this year? O 66.75% O 71.20% O 89.00% O 84.55% , assuming that If Purple Hedgehog Forestry increases its debt ratio, then its dividend payout ratio will all other factors are held constant. If you were to graph a firm's earnings and dividends over the past 20 years, which would you expect to be the most stable over time? The firm's dividends The firm's earnings

Answer 1

Under residual dividend policy, earnings remaining after meeting all profitable investments is distributed as dividend

Capital Budget = $88,000,000

To be financed through Equity = 88,000,000*30% = $26,400,000

Dividend = 240,000,000 – 26,400,000

= $213,600,000

Dividend payout ratio = 213,600,000/240,000,000

= 89.00%

Payout ratio will INCREASE

The firm’s dividends

Dividends are generally more stable than earnings