Question

Circle Inc.'s optimal capital structure calls for 40% debt and 60% common equity. The interest rate on its debt is a constant 12%; its cost of common equity is 18%; and its federal-plus-state tax rate is 40%. Circle Inc. has the following investment opportunities:

Project A: Cost = 5million - IRR = 22%   Project B: Cost = 5million - IRR = 14% Project C: Cost = 5million - IRR = 11%

Circle Inc. expects to have net income of $7 million. If the firm bases its dividends on the residual policy, its payout ratio will be _____%. If your answer is 1.23% then input 1.23 in the answer box.

Answer 1

WACC = After tax cost of debt*Weight of debt + Cost of Equity*weight of Equity

= 12%*(1-40%)*40% + 18%*60%

= 13.68%

Projects whose IRR is higher than WACC should be accepted

Hence, A and B must be accepted

Capital Budget = 5 million + 5 million = $10 million

To be financed through Equity = 10 million*60% = $6 million

Under residual dividend policy, income remaining after meeting potential investment opportunities is paid out as dividend

Hence, Dividend = 7 million - 6 million = $1 million

Payout ratio = Dividend/Net Income

= 1/7

= 14.2857%

i.e. 14.29%