Question

Alternative: Dividend Policies: In 2013, Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. Note that 2013 was a normal year and that for the past 10 years, earnings have grown at 10%. However in 2014, earnings are expected to jump to $14.4 million and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that Keenan will not be able to maintain the 2014 level of earnings growth because of the high 2014 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2014, the company will return to its previous 10% growth rate. Keenan’s target capital structure is 40% debt and 60% equity.

Calculate Keenan’s total Dividends for 2014 assuming that assuming that it follows each of the following policies.

It is 2014 dividend payment is set to force dividends to grow at the long run growth rate in earnings.

It continues the 2013 dividend payout ratio.

It uses a pure residual dividend policy (40% of the 8.4 million investment is financed with debt and 60% with common equity).

It employs a regular- dividend-plus extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual dividend policy.

Which of the preceding polices would you recommend? Restrict your choices to the ones listed but justify your answer.

Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2014 and to have the dividend grow at 10% after 2014. The stocks total market value is $180million. What is the company’s cost of equity?

What is Keenan’s long run average return on equity?

Does a 2014 dividend of $9,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower? Explain your answer..

Answer 1

It is 2014 dividend payment is set to force dividends to grow at the long run growth rate in earnings.

Dividends =$3.6M

Long term growth rate =10%

Dividends = $3.6M*(1+g)

Dividends = $3.6M*(11.1)

Dividends = $3.96M

It continues the 2013 dividend payout ratio

Dividends Payout Ratio= 33.33%

Net Income =14.4M

Target equity Ratio=60%

Capital budget = 16 M

Red Equity = 9.60M

Dividends Paid= 4.80M

It uses a pure residual dividend policy

Debt ratio= 40%

Equity ratio=60%

Distributions=Net income-[(target eqity ratio)(total capital budget)]

Distribution =14.4M-[(60%)(8.4M)]

Distribution=9.36M