Question

Merlo, Inc. maintains a debt-equity ratio of 0.25 and follows a residual dividend policy. The company has after-tax earnings of $2,700 for the year and needs $2,200 for new investments. What is the total amount Merlo will pay out in dividends this year?

$1,660

$940

$0

$400

$440

Answer 1

Answer: The correct option is $940
Equity capital needed by the firm for investment in projects = Amount required for new investments*1/(1+debt to equity ratio)
Amount required for new investments=$2,200
Debt to equity ratio=0.25
Equity capital needed by the firm for investment in projects=$2,200*1/(1+0.25)=$2,200*1/(1.25)=$1760
Given that the net income (after tax earnings)=$2,700
Total amount Merlo, Inc. will pay out in dividends (according to residual dividend policy)=Net income-Equity capital needed by the firm for investment in projects
=$2,700-$1760=$940