Boehm Corporation has had stable earnings growth of 8% a year for the past 10 ye
ID: 2382592 • Letter: B
Question
Boehm Corporation has had stable earnings growth of 8% a year for the past 10 years and in 2013 Boehm paid dividends of $2.6 million on net income of $9.8 million. However, in 2014 earnings are expected to jump to $12.6 million, and Boehm plans to invest $7.3 million in a plant expansion. This onetime unusual earnings growth won’t be maintained, though, and after 2014 Boehm will return to its previous 8% earnings growth rate. Its target debt ratio is 35%.
Calculate Boehm’s total dividends for 2014 under each of the following policies:
2. (a) It uses a pure residual policy with all distributions in the form of dividends (35% of the $7.3 million investment is financed with debt). (b) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.
Explanation / Answer
2. (a) It uses a pure residual policy with all distributions in the form of dividends (35% of the $7.3 million investment is financed with debt).
Retained Earning as per pure residual policy = Investment in plant Expansion - investment is financed with debt
Retained Earning as per pure residual policy = 7.3 - 35%*7.3
Retained Earning as per pure residual policy = $ 4.745 Million
Boehm’s total dividends for 2014 = Earning - Retained Earning as per pure residual policy
Boehm’s total dividends for 2014 = 12.6 - 4.745
Boehm’s total dividends for 2014 = $ 7.855 Million
(b) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.
Regular-dividend = 2.6*(1+8%) = $ 2.808 Million
Extra Dividend = Earning - Retained Earning as per pure residual policy - Regular-dividend
Extra Dividend = 12.6 - 4.745 - 2.808
Extra Dividend = $ 5.047 Million
Boehm’s total dividends for 2014 = Regular-dividend + Extra Dividend
Boehm’s total dividends for 2014 = 2.808 + 5.047
Boehm’s total dividends for 2014 = $ 7.855 Million