Question

RESIDUAL DIVIDEND MODEL

Walsh Company is considering three independent projects, each of which requires a $6 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 = 19%
Project M (medium risk):	Cost of capital = 13%	IRR = 10%
Project L (low risk):	Cost of capital = 7%	IRR = 9%

Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 25% debt and 75% common equity, and it expects to have net income of $10,155,000. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places.

Answer 1

Under residual dividend model, the earnings that are left after all the capital investments are distributed as dividends. Projects to be accepted: Project H and Prokect L Since the IRR is higher than the cost of capital Funds required $ 6 million x 2 $12 million Amount to be financed through Equity 12 million x 75%= $9 million Net Income 10,155,000 Less: Investment ($9,000,000) Dividends $1,155,000 Payout ratio Dividend/Net Income x 100 1,155,000/10,155,000 x 100 11.37%