Question

CH 14:

3. The residual dividend model

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 has generated earnings of $240,000,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $86,000,000 on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure. The company makes distributions in the form of dividends.

What will Purple Hedgehog Forestry Group’s dividend payout ratio be if it follows a residual dividend policy? A,B,C or D

A; 78.50%

B: 70.65%

C: 86.35%

D:58.88%

Purple Hedgehog Forestry Group is considering using more equity and less debt in its capital structure. Which of these statements best describes how this will affect the firm’s annual dividend, assuming that all other factors are held constant? A or B

A: Purple Hedgehog Forestry Group’s annual dividend will be greater if it goes forward with this decision.

B: Purple Hedgehog Forestry Group will pay a smaller annual dividend if it goes forward with this decision.

Green Parrot Cruise Corporation has very stable, predictable earnings, but its capital investment tends to be lumpy. That means that its required capital budget usually is relatively low, but every few years some large expenditures cause the firm’s capital budget to be quite large. Green Parrot Cruise Corporation(CHOOSE ONE: SHOULD OR SHOULD NOT) follow a strict residual dividend policy.

Answer 1

Purple Hedgehog Forestry Group’s dividend payout ratio be if it follows a residual dividend policy

The amount of dividends paid

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

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

= $240,000,000 – [$86,000,000 x 60%]

= $240,000,000 - $51,600,000

= $188,400,000

The Expected Dividend pay-out Ratio for this year

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

= [$188,400,000 / $240,000,000] x 100

= 78.50%

“Hence, Purple Hedgehog Forestry Group’s dividend payout ratio will be 78.50%”

The following statements best describes how this will affect the firm’s annual dividend, assuming that all other factors are held constant

Statement-B: Purple Hedgehog Forestry Group will pay a smaller annual dividend if it goes forward with this decision.

If Green Parrot Cruise Corporation has very stable, predictable earnings, but its capital investment tends to be lumpy. That means that its required capital budget usually is relatively low, but every few years some large expenditures cause the firm’s capital budget to be quite large. Green Parrot Cruise Corporation “SHOULD NOT” follow a strict residual dividend policy.