Question

A firm's/company projected capital budget is $3,000,000, its target capital structure is 50% debt and 50% equity, and its forecasted net income is $1,500,000. If the company follows a residual dividend policy, how much dividends will it pay or, alternatively, how much new stock must it issue?

Answer 1

Sol:

Capital budget = $3,000,000

Target capital ratio = 50% debt and 50% equity

Forecasted net income = $1,500,000

To determine dividends the company will pay is as follows:

A business with a residual dividend policy holds zero excess cash at any given point in time. All spare cash must be either reinvested in the business or redistributed among the shareholders.

Equity Funding = Capital budget x Target capital equity ratio

Equity Funding = $3,000,000 x 50% = $1,500,000

Dividends = Net Income - Equity Funding

Dividends = $1,500,000 - $1,500,000 = 0

Forecasted net income is $1,500,000, since there is no equity left to fund the capital budget the entire income will be retained.

There will be zero cash left over to pay the dividends or to issue new stock.