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 2 million, 53.2 million, and 542 million (3) The forecasted level of potential retained earnings next year is $2 2 million (4) The target or optimal capital structure is a debt ratio of 45%. 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 each of the three capital expenditure amounts. b. Compare, contrast, and discuss the amount of dividends (calculated in part a) associated with each of the three capital expenditure amounts a. If the capital expenditure amount is $2.2 million, the amount of dividend the firm can pay is $(Round to the nearest dollar) If the capital expenditure amount is $2.2 million, the dividend payout ratio is % (Round to one decimal place.) If the capital expenditure amount is $3 2 million, the amount of dividend the firm can pay is $(Round to the nearest dollar.) If the capital expenditure amount is $3.2 million, the dividend payout ratio is % (Round to one decimal place.)

Answer 1

Ans.

Potential retained earnings = $ 2.2 million or $ 2,200,000

Debt ratio = 45%

Capital budget = $ 2.2 million or $ 3.2 million or $ 4.2 million

a)

A/1	B	C	D	E
2	Capital Budget	$ 2,200,000.00	$ 3,200,000.00	$ 4,200,000.00
3	Debt Portion	$      990,000.00	$ 1,440,000.00	$ 1,890,000.00
4	Equity Portion	$ 1,210,000.00	$ 1,760,000.00	$ 2,310,000.00
5	Potential Retained Earnings	$ 2,200,000.00	$ 2,200,000.00	$ 2,200,000.00
6	Dividend	$      990,000.00	$      440,000.00	$                       -
7	Dividend Payout Ratio	45%	20%	0%

Formulas

A/1	B	C	D	E
2	Capital Budget	=2.2*1000000	=3.2*1000000	=4.2*1000000
3	Debt Portion	=+C2*45%	=+D2*45%	=+E2*45%
4	Equity Portion	=+C2-C3	=+D2-D3	=+E2-E3
5	Potential Retained Earnings	=2.2*1000000	=2.2*1000000	=2.2*1000000
6	Dividend	=+C5-C4	=+D5-D4	0
7	Dividend Payout Ratio	=+C6/C5	=+D6/D5	=+E6/E5

Note : When Capital Budget is $ 4.2 million dividend is $ 0 as retained earnings are less than Equity Portion . Here, new stock is to be issued to attain the increased Equity Portion i.e

New Stock = Equity Portion - Retained Earnings = $ 2,310,000 - $ 2,200,000 = $ 110,000

b)

Based on the findings in Part a, the amount of dividend paid is decreases/ reduces as capital expenditure increases.