Question

Kendra Brown is analyzing the capital requirements for Reynold Corporation for next year. Kendra forecasts that Reynold will need $15 million to fund all its positive NPV projects and her job is to determine how to raise the money. Reynold’s net income is $11 million, and it has paid a $2 dividend per share (DPS) for the past several years (1 million of shares of common stock are outstanding). Its shareholders expect the dividend to remain constant for the next several years. The company’s target capital structure is 30% debt and 70% equity.

1. Suppose Reynolds follows the residual model and make all distributions as dividends. How much retained earnings will it need to fund its capital budget?
2. If Reynolds follows the residual model with all distributions as dividends, what will be its dividend per share and payout ratio for the upcoming year?
3. If Reynolds maintains its current $2 DPS for next year, how much retained earnings will be available for the firm’s capital budget?

Answer 1

Under residual dividend policy, earnings remaining after meeting all profitable investment opportunities are paid as dividend

Capital budget = $15,000,000

Retained earnings required = Capital Budget*Share of Equity

= 15,000,000*70%

= $10,500,000

b.Dividend per share = (Net Income – Amount required)/Number of shares

= (11,000,000-10,500,000)/1,000,000

=$0.5 per share

Payout ratio = (11,000,000-10,500,000)/11,000,000

= 4.55%

c.Retained earnings available = 11,000,000 – 1,000,000*2

=$9,000,000