Question

You have gathered the following information about a company you are analyzing:

• Expected net income for the year is $3.0 million
• The company’s current (and target) capital structure is 40 percent debt and 60 percent equity
• The company’s cost of debt is 8 percent
• The company’s cost of equity (and retained earnings) is estimated to be 13 percent
• The company’s tax rate is 30 percent
• The company is considering the following capital investment projects for the year (all projects have same risk as the firm):
  • Project 1 requires an investment of $1 million and has an IRR of 12 percent
  • Project 2 requires an investment of $1.2 million and has an IRR of 11.5 percent
  • Project 3 requires an investment of $1.2 million and has an IRR of 10.75 percent
  • Project 4 requires an investment of $1.5 million and has an IRR of 10.15 percent
  • Project 5 requires an investment of $1 million and has an IRR of 9.75 percent
    

If the company follows a residual dividend policy, what is the company’s payout ratio this year?

Answer 1

after tax cost of debt	cost of debt*(1-tax rate)	8*(1-.3)	5.60%
cost of equity			13%
WACC =(weight of debt*after tax cost of debt)+(weight of equity*cost of equity)	(.5*5.6%)+(.6*13%)		10.60%
Project	Investment	IRR of project	WACC	Accept if IRR> WACC and Reject if IRR<WACC
1	A	12%	10.60%	Accept
2	B	11.50%	10.60%	Accept
3	C	10.75%	10.60%	Accept
4	D	10.15%	10.60%	Reject
5	E	9.75%	10.60%	Reject
total Investment required in three project	1+1.2+1.2		3.4
Amount required from equity in millions	3.4*60%	2.04
Amount required from debt in millions	3.4*40%	1.36
Amount of EBIT in millions		3
amount of equity financed from net income		2.04
amount of profit left for dividend	3-2.04	0.96
Payout ratio = amount left to declare dividend/ebit	.96/3	32%