Question

In a given year, the after-tax earnings of a company is $5,000,000 while
required fund for new positive NPV investments is $1,000,000. The firm’s target
D/E ratio is 0.25. What should be the new debt issuance, new equity issuance,
and dividend payment for the firm based on residual dividend policy?
A. 800,000: 200,000: 0
B. 1,000,000: 1,000,000: 0
C. 1,000,000: 0: 200,000
D. 200,000: 0: 4,200,000
E. 500,000: 0: 4,500,000

Answer 1

The investment in new project should be in same D/E proportion as the target structure of company.

D/E = 0.25 or D/E = 0.25/1

D/(D + E) = 0.25/1.25 = 20%

E/(D+E) = 80%

Hence, 80% of $1,000,000 comes from equity and 20% from debt

Amount of debt required = 20% * $1,000,000 = $200,000 --> To be issued

Amount of Equity Required = 80% * $1,000,000 = $800,000 --> This could come from the after tax earnings. So no new equity needs to be issued

Amount of dividend (based on Residual dividend policy) = $5,000,000 - $800,000 = $4,200,000

So the ratio of new debt issuance, new equity issuance, and dividend payment would be $200,000: 0 : $4,200,000. Answer is Option d