Question

Residual dividend policy As president of Young's of California, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks about the company's dividend policy. In fact, the stockholder has asked you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you do know the following: (1) The company follows a residual dividend policy. (2) The total capital budget for next year is likely to be one of three amounts, depending on the results of capital budgeting studies that are currently under way. The capital expenditure amounts are $2.1 million, $3.1 million, and $4.1 million (3) The forecasted level of potential retained earnings next year is $2.1 million (4) The target or optimal capital structure is a debt ratio of 35%. You have decided to respond by sending the stockholder the best information available to you. a. Compute the amount of the dividend (or the amount of new common stock needed) and the dividend payout ratio for

Answer 1

a. Amount of the dividend and dividend payout ratio for each of the three capital expenditure amounts:

Under residual dividend policy, dividend is distributed only after using the retained earnings first for capital expenditures in the form of equity and only the residual amount (after funding capital expenditure) will be distributed as dividend.

A B с D 1 2 Retained Earnings $2,100,000 3 Target Debt Ratio 35% 4 5 Capital Expenditures $2,100,000 $3,100,000 $4,100,000 6 Debt Component $735,000 $1,085,000 $1,435,000 7 Balance Funding Required through Equity $1,365,000 $2,015,000 $2,665,000 8 Retained Earnings used $2,100,000 $2,100,000 $2,100,000 Dividend Paid (Under Residual Dividend 9 Policy) $735,000 $85,000 $0 10 Dividend Payout Ratio 35.00% 4.05% 0.00% 11 New Common Stock Needed $0 $0 $565,000 12

Workings:

b. The Dividend Paid and dividend payout ratio reduces as the capital expenditure increases. This is because of the dividend residual policy which the company has adopted. Since the dividend is paid under residual policy and the amount of retained earnings is fixed, any increase in capital expenditure (beyond the % required for debt) will result in company paying less dividends and increase in capital expenditure beyond the retained earnings will result in no dividend.