Question

Sandwich Company is considering five independent projects, each of the project will require a $10 million investment. The estimated IRR and cost of capital for these projects are presented as follows: Project A Cost of capital = 12% RR = 14% Project B Cost of capital = 14% IRR = 12% Project C Cost of capital = 8% IRR = 10% Project D Cost of capital = 9% IRR = 10% Project E Cost of capital = 16,5% IRR = 15% The company's optimal capital structure calls for 50% debt and 50% common equity, and it expects to have net income of $25,000,000. a. If Sandwich Company chooses 3 projects, which projects will Sandwich Company choose? If Sandwich establishes its dividends from the residual dividend model, what will be its payout ratio?

Answer 1

Expected Dividend Pay-out Ratio using residual dividend model

Step-1, Determination of total Investment cost by comparing the Project’s IRR with their cost of capital

We know that the project should be accepted only if the IRR is greater than the cost of capital. Here, the IRR for the Project-A, Project-C and Project-D are greater than their cost of capital and therefore, the Project-A, Project-C, Project-D should be accepted.

Hence, the total Investment cost will be $30,000,000 [$10,000,000 x 2]

Step-2, Calculation of Total Dividend paid

Total Dividend paid using the residual dividend policy is calculated as follows

Total Dividend = Net Income – [Total Capital Budget x Equi                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 ty Ratio]

= $25,000,000 – [$30,000,000 x 50%]

= $25,000,000 - $15,000,000

= $10,000,000

Step-3, The Expected Dividend Pay-out Ratio for this year

Therefore, the Expected Dividend Pay-out Ratio = [Total Dividend Paid / Net Income] x 100

= [$10,000,000 / $25,000,000] x 100

= 40.00%

“Hence, the Expected Dividend Pay-out Ratio will be 40.00%”