Question

As president of Young’s of California, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks about the company’s dividend policy. In fact, the stockholder has asked you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you do know the following:

(1) The company follows a residual dividend policy

(2) The total capital budget for next year is likely to be of three amounts, depending on the results of the capital budgeting studies that are currently under way. The capital expenditure amounts are $2 million, $3 million, and $4 million.

(3) The forecasted level of potential retained earnings next year is $2 million.

(4) The target or optimal capital structure is a debit ratio of 40%.

You have decided to respond by sending the stockholder the best information available to you.

a. Describe a residual dividend policy.

b. Compute the amount of the dividend (or the amount of new common stock needed) and the dividend payout ratio for each of the three capital expenditure amounts

c. Compare, contrast, and discuss the amounts of dividends (calculated in part b) associated with each of the three capital expenditure amounts.

Answer 1

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a. Describe a residual dividend policy.
A residual policy is when companies first use the cash flow to fullfill necessary capital expenditures. Once the capital expenditures are taken care of, then the remaining amount available (the residual) is used to fund dividend payments.
															b. Compute the amount of the dividend (or the amount of new common stock
needed) and the dividend payout ratio for each of the three capital expenditure
amounts.
Capital Expenditures			$20,00,000	$30,00,000	$40,00,000
Debt Ratio			40%	40%	40%
Debt Amount			$8,00,000	$2,00,000	$16,00,000
Equity Amount			$12,00,000	$18,00,000	$24,00,000
Dividend Amount			$8,00,000	$2,00,000	$0
Dividend Payout Ratio			40%	10%	0%
c. Compare, contrast, and discuss the amount of dividends (calculated in part b)
associated with each of the three capital expenditure amounts.
It is apparent that the residual dividends decrease as the capital expenditures have increased.
As shown in part B, when the capital expenditures was $2 million the dividend amount was $800,000.
This amount was reduced to $0 when the capital expenditures reached $4 million.