Middlesex Plastics Manufacturing had 2011 Net Income of $15.0 Million. Its 2012
ID: 2673649 • Letter: M
Question
Middlesex Plastics Manufacturing had 2011 Net Income of $15.0 Million. Its 2012 Net Income is forecast to increase by 8%. The company’s capital structure has been 35% Debt and 65% Equity since 2010, and the company plans to maintain this capital structure in 2012. The company paid $3.0 Million cash dividends in 2011. The company is planning to invest in a major capital project in 2012. The capital budget for this project is $12.0 Million in 2012.1. If Middlesex increases its cash dividends in 2012 at the same rate of growth as its Net Income rate, what will be the total 2012 dividend payout in Dollars?
2. What is the 2012 dividend payout ratio if the company increases its dividends at 8%?
3. If the company follows a residual dividend policy, and maintains its 35% Debt level in its capital structure, and invests in the $12.0 Million capital budget in 2012, what would be the Residual Dividend level (in Dollars) in 2012? What would be this Residual Dividends payout ratio?
4. How much additional capital (Debt and/or Equity) will the company have to raise from outside sources in 2012 if it invests in this capital project, and follows a residual dividend policy?
5. What would be the prudent dividend policy for 2012?: Pay dividends at the current dividend growth rate of 8%, or pay the residual dividend amount.
Explanation / Answer
Calculation of Residual dividend policy: Let's suppose that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, suppose this company has a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay for one-third of this project by using debt ($300) and two-thirds ($600) by using equity. In other words, the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000 - $600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000 - $1,000) for dividends. If any project required an equity portion that was greater than the company's available levels, the company would issue new stock In opposition to these two arguments is the idea that a high dividend payout is important for investors because dividends provide certainty about the company's financial well-being; dividends are also attractive for investors looking to secure current income.