Problem 14-9 Residual Distribution Policy Harris Company must set its investment
ID: 2720584 • Letter: P
Question
Problem 14-9
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:
Harris intends to maintain its 25% debt and 75% common equity capital structure, and its net income is expected to be $12,828,000. 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.
%
Project A: Cost of capital = 15%; IRR = 21% Project B: Cost of capital = 14%; IRR = 16% Project C: Cost of capital = 8%; IRR = 6%Explanation / Answer
Answer
Companies that use the residual dividend policy first use the cash flow to fulfil necessary capital expenditures and the remaining amount available (the residual) is paid out to shareholders. Also, if the company is maintaining a certain target debt to equity capital structure, then the full amount of the capital expenditure will not be paid entirely by equity but also with part debt.
Project A and Project B will be accepted because their IRR is greater than Cost of capital.
Project C will not be accepted as its IRR is less than cost of capital.
Total investment required is $ 10 million ($ 5 million + $ 5 million).
Harris intends to maintain its 25% debt and 75% common equity capital structure. So 2.5 million (10 million*25%) will be funded by way of debt and 7.5 million (10 million*75%) will be funded by way of equity.
its net income is expected to be $12,828,000 out of which $ 7,500,000 will go to fund project A and Project B. So Total dividend will be paid of $ 5,328,000 ($12,828,000 - $7,500,000)
So Dividend pay-out ratio (dividend/ net income) will be 41.53% ($5,328,000/$12,828,000).