Chapter 15, Problem 10SP

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% equity and 40% debt, it has 1,000,000 shares of common equity outstanding, and its net income is $8 million. The company forecasts that it will require $10 million to fund all of its profitable (i.e., positive NPV) projects for the upcoming year.

1. a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?
2. 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?
3. 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?
4. d. Can the company maintain its current capital structure, the $3.00 DPS, and a $10 million Capital budget without having to raise new common stock?
5. e. Suppose that Buena Terra's management is firmly opposed to cutting the dividend; that is, it wants 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?
6. 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% equity and 40% debt) and its $10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue to meet each of its objectives?
7. 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 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?
8. h. What actions can a firm that follows the residual dividend model take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?

Summary Introduction

To calculate: Amount of retained earnings required for funding the capital budget.

Introduction:

Residual Dividend Policy: Under the residual dividend policy, the company gives first preference to the current capital investment. The amount remaining after the capital investment is distributed among the shareholders as dividend.

Explanation of Solution

Calculate retained earnings.

Given,

Capital budget is $10,000,000.

Capital structure is 60% equity.

Formula to calculate retained earnings,

$\text{Retained}\text{earnings}\text{needed}=\text{Capital}\text{budget}\times \text{Equity}\text{\%}$

Substitute $10,000,000 for capital budget and 60% for equity %.

$\begin{array}{c}\text{Retained}\text{earnings}\text{needed}=\$10,000,000\times 60\%\\ =\$6,000,000\end{array}$

Conclusion

Retained earnings required to fund the capital budget is $6,000,000

Summary Introduction

To calculate: Company’s dividend per share and payout ratio.

Explanation of Solution

Calculate residual dividend.

Given,

Net income is $8,000,000.

Retained earnings are $6,000,000.

Formula to calculate residual dividend,

$\text{Residual}\text{dividend}=\text{Net}\text{income}-\text{Retained}\text{earnings}$

Substitute $8,000,000 for net income and $6,000,000 for retained earnings.

$\begin{array}{c}\text{Residual}\text{dividend}=\text{\$8,000,000}-\$6,000,000\\ =\$2,000,000\end{array}$

So,residual dividend is $2,000,000.

Calculate dividend per share.

Given,

Residual dividend is $2,000,000.

Shares outstanding are 1,000,000.

Formula to calculate dividend per share,

$\text{Dividend}\text{per}\text{share}=\frac{\text{Residual}\text{dividend}}{\text{Shares}\text{Outstanding}}$

Substitute $2,000,000 for residual dividend and 1,000,000 for shares outstanding.

$\begin{array}{c}\text{Dividend}\text{per}\text{share}=\frac{\text{\$2,000,000}}{\text{1,000,000}}\\ =\$2\end{array}$

So, dividend per share is $2.

Calculate payout ratio.

Given,

Residual dividend is $2,000,000.

Net income is $8,000,000.

Formula to calculate payout ratio,

$\text{Payout}\text{ratio}=\frac{\text{Residual}\text{dividend}}{\text{Net}\text{income}}$

Substitute $2,000,000 for residual dividend and $8,000,000 for net income.

$\begin{array}{c}\text{Payout}\text{ratio}=\frac{\$2,000,000}{\text{\$8,000,000}}\\ =0.25\\ =25\%\end{array}$

So, payout ratio is 25%.

Conclusion

The dividend per share is $2 while the payout ratio is 25%

Summary Introduction

To calculate: Retained earnings at $3 dividend per share for the next year.

Explanation of Solution

Calculate retained earnings.

Given,

Net income is $8,000,000.

Shares outstanding are 1,000,000.

Dividend per share is $3.

Formula to calculate retained earnings available,

$\text{Retaind}\text{earnings}\text{available}=\left[\begin{array}{l}\text{Net}\text{Income}\\ -\text{Dividend}\text{per}\text{share}\left(\text{Outstanding}\text{shares}\right)\end{array}\right]$

Substitute $8,000,000 for net income, 1,000,000 for outstanding shares and $3 for dividend per share.

$\begin{array}{c}\text{Retaind}\text{earnings}\text{available}=\text{\$8,000,000}-\text{\$3}\left(1,000,000\right)\\ =\$5,000,000\end{array}$

Conclusion

The retained earnings available will be of $5,000,000.

Summary Introduction

To explain: Whether it is possible to maintain current capital structure at $3 dividend per share and the capital budget of $10 million without raising new stock.

Answer to Problem 10SP

No, it is not possible.

Explanation of Solution

• It is not possible because at $3 dividend per share the retained earnings available are of only $5,000,000.
• If the company doesn’t want to change its current capital structure, then the equity of $6,000,000 will be required and to arrange this amount of equity, company has to issue additional stock of $1,000,000.

Conclusion

So, to maintain current capital structure, it is required to issue additional stock of $1,000,000.

Summary Introduction

To calculate: Portion of capital budget to be financed for the debt.

Explanation of Solution

Calculate retained earnings.

Given,

Net income $8,000,000

Dividend $3,000,000

Formula to calculate retained earnings available,

$\text{Retained}\text{earnings}\text{available}=\text{Net}\text{income}-\text{Dividends}$

Substitute $8,000,000 for net income and $3,000,000 for dividend.

$\begin{array}{c}\text{Retained}\text{earnings}\text{available}=\text{\$8,000,000}-\$3,000,000\\ =\$5,000,000\end{array}$

So, retained earnings available are $5,000,000.

Calculateportion of capital budget financed with retained earnings.

Given,

Retained earnings are $5,000,000.

Capital budget is $10,000,000.

Formula to calculate portion of capital budget financed with retained earnings,

$\left[\begin{array}{l}\text{Portion of capital budget}\\ \text{financed with retained earnings}\end{array}\right]=\left[\frac{\text{Retained}\text{earnings}\text{available}}{\text{Capital}\text{Budget}}\right]$

Substitute $10,000,000 for capital budget and $5,000,000 for retained earnings.

$\begin{array}{c}\left[\begin{array}{l}\text{Portion of capital budget}\\ \text{financed with retained earnings}\end{array}\right]=\frac{\$5,000,000}{\$10,000,000}\\ =50\%\end{array}$

So, portion of capital budget financed with retained earnings is 50%.

Calculate portion of capital budget financed with debt.

Given,

Amount available for debt is $5,000,000.

Capital budget is $10,000,000.

Formula to calculate portion of capital budget financed with debt,

$\text{Portion of capital budget financed with debt}=\frac{\text{Amount}\text{of}\text{debt}\text{available}}{\text{Capital}\text{budget}}$

Substitute $10,000,000 for capital budget and $5,000,000 for amount available for debt.

$\begin{array}{c}\text{Portion of capital budget financed with debt}=\frac{\$5,000,000}{\$10,000,000}\\ =50\%\end{array}$

Conclusion

So, portion of capital budget financed with debt is 50%.

Summary Introduction

To calculate: The new stock the company would have to issue to meet its objectives.

Explanation of Solution

Calculate equity needed.

Given,

Capital budget is $10,000,000.

Capital structure is 60% equity.

Formula to calculate equity needed,

$\text{Equity}\text{needed}=\text{Capital}\text{budget}\times \text{Equity}\text{\%}$

Substitute $10,000,000 for capital budget and 60% for equity.

$\begin{array}{c}\text{Equity}\text{needed}=\$10,000,000\times 60\%\\ =\$6,000,000\end{array}$

So, equity needed is of $6,000,000.

Calculate retained earnings available.

Given,

Net income is $8,000,000.

Shares outstanding are 1,000,000.

Dividend per share is $3.

Formula to calculate retained earnings available,

$\text{Retaind}\text{earnings}\text{available}=\left[\begin{array}{l}\text{Net}\text{Income}\\ -\text{Dividend}\text{per}\text{share}\left(\text{Outstanding}\text{shares}\right)\end{array}\right]$

Substitute $8,000,000 for net income, 1,000,000 for outstanding shares and $3 for dividend per share.

$\begin{array}{c}\text{Retaind}\text{earnings}\text{available}=\text{\$8,000,000}-\text{\$3}\left(1,000,000\right)\\ =\$5,000,000\end{array}$

So, retained earnings available are $5,000,000.

Calculatenew equity needed.

Given,

Equity needed is $6,000,000.

Retained earnings available are $5,000,000.

Formula to calculate new equity needed,

$\text{New}\text{equity}\text{needed}=\text{Equity}\text{needed}-\text{Retained}\text{earnings}\text{available}$

Substitute $5,000,000 for retained earnings available and $6,000,000 for equity needed.

$\begin{array}{c}\text{New}\text{Equity}\text{needed}=\text{\$6,000,000}-\$5,000,000\\ =\$1,000,000\end{array}$

Conclusion

Amount of new stock that the company would have to issue to meet its objectives is of$1,000,000.

Summary Introduction

To calculate: Capital budget for next year.

Explanation of Solution

Calculate retained earnings available.

Given,

Net income is $8,000,000.

Share outstanding is 1,000,000.

Dividend per share is $3.

Formula to calculate retained earnings available,

$\text{Retaind}\text{earnings}\text{available}=\left[\begin{array}{l}\text{Net}\text{Income}\\ -\text{Dividend}\text{per}\text{share}\left(\text{Outstanding}\text{shares}\right)\end{array}\right]$

Substitute $8,000,000 for net income, 1,000,000 for outstanding shares and $3 for dividend per share.

$\begin{array}{c}\text{Retaind}\text{earnings}\text{available}=\text{\$8,000,000}-\text{\$3}\left(1,000,000\right)\\ =\$5,000,000\end{array}$

So, retained earnings available are $5,000,000.

Calculate capital budget.

Given,

Required equity is $5,000,000.

Equity ratio is 60%.

Formula to calculate capital budget,

$\text{Required}\text{Equity}=\text{Capital}\text{budget}\times \text{Target}\text{equity}\text{ratio}$

Substitute $5,000,000 for required equity and 0.6 for target equity ratio,

$\begin{array}{c}\text{\$5,000,000}=\text{Capital}\text{budget}\times \text{0}\text{.6}\\ \text{Capital}\text{budget}=\frac{\$5,000,000}{0.6}\\ =\$8,333,333.333\end{array}$

Conclusion

Capital budget required is of $8,333,333.333.

Summary Introduction

To explain: Actions to be taken when forecasted retained earnings are lesser than the required earnings.

Answer to Problem 10SP

The firm has to take certain steps to fix this.

Explanation of Solution

• A firm can cut its dividend to meet the requirement.
• Changing the capital structure that is using more debt will work in favor.
• Reducing the capital budget and issuing new common stock will work as a wonder for the firm.

Conclusion

The above explained steps will help the firm in case when the forecasted retained earnings are less than required earnings.