Question

Great Lakes Sports Store (GLSS) has just completed its review of proposed projects for the coming year and has determined that it would like to invest a total of $389,000 in new projects. The firm follows a residual dividend policy and has a target debt-equity ratio of .55. GLSS wants to pay dividends totaling $40,000 this year. To do so, how much must the firm earn in annual aftertax income?

a. $253,950

b. $290,968

c. $178,032

d. $284,050

e. $194,368

Answer 1

Step-1, Calculation of Weight of Equity

Weight of Equity = 1 / [1 + Debt-equity ratio]

= 1 / [1 + 0.55]

= 1 / 1.55

= 0.645161 or

= 64.5161%

Step-2, Calculation of the annual aftertax income using the residual dividend policy

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

Total Dividend paid = Annual after-tax income - [Total Capital Budget x Equity Ratio]

$40,000 = Annual after-tax income – [$389,000 x .645161]

$40,000 = Annual after-tax income - $250,968

Therefore, the annual after-tax income = $250,968 + $40,000

Annual after-tax income = $290,968