Question

Milk Boy is a local dairy products manufacturer. The company is preparing a nancial plan for the coming year and has the following independent production projects under consideration:

Project	Initial investment ($ million)	Internal rate of return (%)
A	70	16.00%
B	95	17.00%
C	80	13.00%
D	50	20.00%
E	65	18.00%

Suppose the above projects have the same risk as that of the company’s existing operation. Also, the chief nancial of cer of Milk Boy estimates that earnings after tax in this nancial year will be $125 million. Milk Boy has 20 million ordinary shares outstanding and the cost of capital (WACC) of the company is 16.50%. The board would like to maintain a debt-to-equity ratio (D/E) of 3.

i. Based on the above information, determine which project(s) should be accepted by the company. Calculate the rm’s total planned capital expenditure for the coming year. ?

ii. Suppose Milk Boy follows a residual dividend policy. What will be the company’s dividend per share?

iii. Provide TWO major disadvantages of a strict residual dividend policy. How does a compromise dividend policy differ from a strict ?residual dividend policy?

Answer 1

1.Based on the above information it is ample clear that Milk Boy's cost of capital is 16.5%, therefore select the projects whose IRR is greater than or equal to 16.5% i.e., project B,D & E.

Total capital outlay = USD 95 +50 +65 = USD 210 millions

2. If Milk Boy adopts Residual Dividend Policy then following are the DPS

Total Outlay = USD 210 millions

Debt : 210 *3 /4 = USD 157.5 millions

Equity: 210 - 157.5 = USD 52.5 millions

Dividend to be distributable = USD 125 millions - USD 52.5 millions

= USD 85 millions

DPS = 85/20 = USD 4.25 / share

3. Disadvantages of Residual dividend policy :

Variable dividends send conflicting signals, increase risk, and do not appeal to any specific clientele. Results in higher required return.