Question

Big Company needs $800,000 in order to buy a new equipment for its business. Big's net income is 51,300,000. Their target capital structures DIE 13. How much Big can pay out as dividends? Select one O a $720,000 OD $710.000 c. $730,000 O d. $700,000

Answer 1

Answer)

Calculation of amount that can be paid as dividends

Debt to Equity ratio = Debt/Equity

1/3 = Debt/ Equity

Debt = Equity X 1/3    

Debt = Equity/3          ..................... Equation 1

Let the amount of equity be $ Y.

Therefore debt will be $ Y/3     (Refer Equation 1).

The company needs to buy new equipment worth $ 800,000. This amount will be partially funded by Equity and balance by Debt. Therefore, the total amount of Debt and Equity will be equal to $ 800,000.

Purchase price of machine = Debt + Equity

$ 800,000 = $ Y + $ Y/ 3

$ 800,000= $ 4Y/3

Y = ($ 800,000 X 3)/ 4

Y = $ 600,000

Therefore the amount of equity should be $ 600,000.

Debt = Equity/3

         = $ 600,000/3

         =$ 200,000    

        

Next, the company has earned a net income of $ 1,300,000. The undistributed portion of this net income will form part of reserves and surplus which is ultimately Shareholders’ Equity.

Thus out of total Assets in the form of Equipment, the company needs Equity of $ 600,000 and Debt of $ 200,000 to maintain a debt equity ratio of 1/3.

It implies that out of Net Income of $ 1,300,000 the company needs to retain $ 600,000 and balance can be distributed as dividends.

Amount of dividends that the company can pay = Net Income - $ 600,000

                                                                                       =$ 1,300,000 - $ 600,000

                                                                                        =$ 700,000

Therefore the amount that the company can payout as dividends is $ 700,000 and the correct answer in the given question is (d).