Question

Problem 14-09 Residual Distribution Policy

Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose, each of which requires a $5 million investment. These projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and costs of capital are as follows: Project A: Cost of capital = 18%; IRR = 20% Project B: Cost of capital = 12%; IRR = 16% Project C: Cost of capital = 9%; IRR = 10% Harris intends to maintain its 60% debt and 40% common equity capital structure, and its net income is expected to be $13,258,000. If Harris maintains its residual dividend policy (with all distributions in the form of dividends), what will its payout ratio be? Round your answer to two decimal places.

Answer 1

Residual dividend policy is type of dividend policy in which first company use its earnings for the capital investment in current. The amount remained after fulfilling all the obligation of capital investment, pays to shareholder as dividend.

Since, IRR of All three Project is higher than cost of capital , so all three project can be accepted.

So total capital investment = $15 million.

Weight of equity = 40%

Total Total Equity required in capital project = $15 million × 40%

= $6 million.

Total Equity required for capital project is $6 million or $6,000,000.

Total Net income = $13,258,000.

Dividend pais = $13,258,000 - $6,000,000

= $7,258,000

Total amount remains for dividend payment is $7,258,000.

Payout ratio = $7,258,000 / $13,258,000

= 54.74%

Payout ratio is 54.74%.