Residual dividend model Buena Terra Corporation is reviewing its capital budget for
the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several
years, and its shareholders expect the dividend to remain constant for the next several
years. The company’s target capital structure is 60 percent equity and 40 percent debt; it
has 1,000,000 shares of common equity outstanding; and its net income is $8 million. The
company forecasts that it would require $10 million to fund all of its profitable (that is,
positive NPV) projects for the upcoming year.
a. If Buena Terra follows the residual dividend model, how much retained earnings
will it need to fund its capital budget?
b. If Buena Terra follows the residual dividend model, what will be the company’s dividend
per share and payout ratio for the upcoming year?
c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained
earnings will be available for the firm’s capital budget?
d. Can the company maintain its current capital structure, maintain the $3.00 DPS,
and maintain a $10 million capital budget without having to raise new common
stock?
e. Suppose that Buena Terra’s management is firmly opposed to cutting the dividend;
that is, it wishes to maintain the $3.00 dividend for the next year. Also, assume that
the company was committed to funding all profitable projects and was willing to
issue more debt (along with the available retained earnings) to help finance the company’s
capital budget. Assume that the resulting change in capital structure has a
minimal effect on the company’s composite cost of capital, so that the capital budget
remains at $10 million. What portion of this year’s capital budget would have to be
financed with debt?
f. Suppose once again that Buena Terra’s management wants to maintain the $3.00
DPS. In addition, the company wants to maintain its target capital structure (60 percent
equity and 40 percent debt) and maintain its $10 million capital budget. What is
the minimum dollar amount of new common stock that the company would have to
issue in order to meet each of its objectives?
g. Now consider the case where Buena Terra’s management wants to maintain the
$3.00 DPS and its target capital structure, but it wants to avoid issuing new common
stock. The company is willing to cut its capital budget in order to meet its other
objectives. Assuming that the company’s projects are divisible, what will be the
company’s capital budget for the next year?
h. What actions can a firm that follows the residual dividend policy take when its forecasted
retained earnings are less than the retained earnings required to fund its capital
budget?
4 answers
Capital budget = $10,000,000; Capital structure = 60% equity, 40% debt;
Common shares outstanding = 1,000,000.
Retained earnings needed = $10,000,000(0.6) = $6,000,000.
b. If Buena Terra follows the residual dividend model, what will be the company’s dividend per share and payout ratio for the upcoming year?
According to the residual dividend model, only $2 million is available for dividends.
NI - Retained earnings needed for capital projects = Residual dividend
$8,000,000 - $6,000,000 = $2,000,000.
DPS = $2,000,000/1,000,000 = $2.00.
Payout ratio = $2,000,000/$8,000,000 = 25%.
c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available for the firm’s capital budget?
Retained earnings available = $8,000,000 - $3.00(1,000,000)
Retained earnings available = $5,000,000.
d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain a $10 million capital budget without having to raise new common stock?
No. If the company maintains its $3.00 DPS, only $5 million of retained earnings will be available for capital projects. However, if the firm is to maintain its current capital structure $6 million of equity is required. This would necessitate the company having to issue $1 million of new common stock.
e. Suppose that Buena Terra’s management is firmly opposed to cutting the dividend; that is, it wishes to maintain the $3.00 dividend for the next year. Also, assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the company’s capital budget. Assume that the resulting change in capital structure has a minimal effect on the company’s composite cost of capital, so that the capital budget remains at $10 million. What portion of this year’s capital budget would have to be financed with debt?
Capital budget = $10 million; Dividends = $3 million; NI = $8 million;
Capital structure = ?
RE available = $8,000,000 - $3,000,000 = $5,000,000.
Percentage of capital budget financed with RE = $10,000,00
$5,000,000
= 50%.
Percentage of capital budget financed with debt = $10,000,00
$5,000,000
= 50%
f. Suppose once again that Buena Terra’s management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its target capital structure (60 percent equity and 40 percent debt) and maintain its $10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue in order to meet each of its objectives?
Dividends = $3 million; Capital budget = $10 million; 60% equity, 40% debt; NI = $8 million.
Equity needed = $10,000,000(0.6) = $6,000.000.
RE available = $8,000,000 - $3.00(1,000,000) = $5,000,000.
External (New) equity needed = $6,000,000 - $5,000,000
= $1,000,000.
g. Now consider the case where Buena Terra’s management wants to maintain the $3.00 DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming that the company’s projects are divisible, what will be the company’s capital budget for the next year?
Dividends = $3 million; NI = $8 million; Capital structure = 60% equity, 40% debt.
RE available = $8,000,000 - $3,000,000 = 5,000,000.
We’re forcing the RE available = Required equity to fund the new capital budget.
Required equity = Capital budget (Target equity ratio)
$5,000,000 = Capital budget (0.6)
Capital budget = $8,333,333.
Therefore, if Buena Terra cuts its capital budget from $10 million to $8.33 million, it can maintain its $3.00 DPS, its current capital structure, and still follow the residual dividend policy.
h. What actions can a firm that follows the residual dividend policy take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?
The firm can do one of four things:
(1) Cut dividends.
(2) Change capital structure, that is, use more debt.
(3) Cut its capital budget.
(4) Issue new common stock.
_________________________________________________________________________
12 million before tax
331.89
Could you please set up the equations?
0 answers