Question

# RESIDUAL DIVIDEND MODEL Walsh Company is considering three independent projects, each of which requires a \$6...

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.

%

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%