Question

RESIDUAL DIVIDEND MODEL

Walsh Company is considering three independent projects, each of which requires a $6 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here:

Project H (high risk):	Cost of capital = 17%	IRR = 19%
Project M (medium risk):	Cost of capital = 14%	IRR = 11%
Project L (low risk):	Cost of capital = 8%	IRR = 9%

Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 60% debt and 40% common equity, and it expects to have net income of $8,160,000. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places.

%

Answer 1

Only those projects will be accepted whose IRR is greater than the cost of capital

i.e. Projects H and L must be selected

Amount required for investment = 6 million*2 = $12 million

To be funded through Equity = 12,000,000*40% = $4,800,000

Under Residual model, income remaining after meeting expenditure for all profitable projects is distributed as dividend

Hence, amount of dividend = 8,160,000 – 4,800,000 = $3,360,000

Hence, payout ratio = Dividend/Income

= 3,360,000/8,160,000

= 41.1765%

i.e. 41.18%