Question

Sandhurst Enterprises has a target debt/equity ratio of 1/3. It has internally generated after tax cash flows of $118,000,000. Which can be paid out in whole or in part as dividend? It has a corporate tax rate of 40% and cost of capital of 12%. It is considering the following projects. Project U a perpetual project requires investment of $30,000,000. It will provide before tax cash flow of $6,000,000 one year from today and $6,300,000 two years from today. After that cash flow will decline at the rate of 6% per year forever. Its required rate of return is 12%. Project V a perpetual project requires investment of $50,000,000. It will provide before tax cash flow of $10,000,000 per year in perpetuity. Its required rate of return is 10%. Project W a 10 year project requires investment of $70,000,000. It will provide before tax cash flow of $15,000,000 one year from today. After that cash flows will rise at the rate of 10% per year for 9 years. Its required rate of return is 14%. Project X a 25 year project requires $60,000,000 investment. It will provide after tax cash flows of $5,000,000 per year for 10 years and after that $10,000,000 per year for an additional 15 years. Its required rate of return is 8%. Using the residual dividend policy approach determine which of these four projects Sandhurst should invest in and what should be the dividend payout.

Answer 1

NPV of Project U=-30000000+6000000*(1-40%)/1.12+6300000*(1-40%)/1.12*1/(12%-(-6%))=-8035714.286

NPV of Project V=-50000000+10000000*(1-40%)/10%=10000000

NPV of Project W=-70000000+15000000*(1-40%)/1.14*(1-(1.1/1.14)^10)/(1-(1.1/1.14))=-2420343.722

NPV of Project X=-60000000+5000000/1.08*(1-1/1.08^10)/(1-1/1.08)+10000000/1.08^11*(1-1/1.08^15)/(1-1/1.08)=13197354.89

We accept only positive NPV projects hence accept Project V and Project X

Total investment=50000000+60000000=110000000

Equity required=110000000*3/4=82500000

Internally generated cash flows remaining after investing in projects=118000000-82500000=35500000

Dividend Paid=35500000

Dividend Payout %=35500000/118000000=30.0847%