Please show me how to solve, answer is below: Harris Company must set its invest
ID: 2731388 • Letter: P
Question
Please show me how to solve, answer is below:
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 $3 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 = 17%; IRR = 20%
Project B: Cost of capital = 13%; IRR = 10%
Project C: Cost of capital = 7%; IRR = 9%
Harris intends to maintain its 35% debt and 65% common equity capital structure, and its
net income is expected to be $4,750,000. If Harris maintains its residual dividend policy
(with all distributions in the form of dividends), what will its payout ratio be?
*Payout = 17.89%.
Explanation / Answer
In order to calculate the payout ratio, firstly we need to understand the meaning of residual dividend policy.
Residual dividend policy is the policy in which the company uses residual or leftover equity to fund dividend payments. Here, residual or leftover equity means the equity or net income left after meeting the capital expenditures.
In the given question, out of the three projects, Project A and Project C will be undertaken as the respective IRR of these projects is greater than their cost of capital which signifies that these projects will have positive Net Present Values which signifies an increase in shareholder's wealth. Since in case of Project B, IRR is less than cost of capital it shall not be undertaken.
Now, to undertake Project A and C a total expenditure of $ 6 (3+3) million will have to be incurred.
Also Harris intends to maintain its capital structure in the ratio of 35% Debt and 65% equity which implies that out of total expenditure of $6 million, Harris will pay 35% of this expenditure by using debt (i.e.,$2.1million) and 65% by using equity(i.e.,3.9million).
The company has net income of $47,50,000.
Now out of total net income of $47,50,000, $39,00,000 will be used as equity to finance the capital expenditure on the projects and the balance of $21,00,000 ($60,00,000-39,00,000) will be borrowed to finance the capital expenditure.
Therefore, the leftover equity will be $(47,50,000-39,00,000) = $8,50,000, which will be distributed in the form of dividends.
Also, Payout Ratio = Amount distributed as dividends/Net Earnings
Here, Net Earnings= Net income= $47,50,000.
Hence, Payout Ratio = 8,50,000/47,50,000 = 17.89%.