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%**

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