Question

Rhubarb Resources has a debt to equity ration of 3 that they wish to maintain and new investments would cost $120 million this year. The firm expects earning of $25 million this year. a) Calculate dividends paid and external equity financing required if the firm follows a residual dividend policy. b) Calculate dividends paid and external equity financing required if the firm has a fixed payout ratio of 25% c) Calculate the maximum investment funds available without issuing new equity and the increase in debt financing required.

Answer 1

Current debt Equity Ratio = 3

Which means that Debt is 3 times of Equity

And the compnay expects to maintain the same ratio.

Cost of New investments/Amount of Funds Required = $120 Million

Raised from Equity = 120/4 = $30 million

Earning = $25 million

a) Under Residual Dividend Policy, Dividends are paid from whatever is left after financing all investments

Since Earnings are less than the amount required from equity, Dividends paid will be 0

External Equyity Financing Required = $30 million - $25 Million = $5 million

b)Fixed Payout Ratio = 25%

Dividends Paid = $25 million*25% = $6.25 million

External Equity Financing Required = 30 - (25-6.25) = $11.25 Million

c)Maximum Investible Funds available without Issuing New Equity and Increase in Debt Financing = Earnings

= $25 million.