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Chapter 14: Problem 5

Petersen Company has a capital budget of \(\$ 1.2\) million. The company wants to maintain a target capital structure that is 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be \(\$ 600,000\). If the company follows a residual dividend policy, what will be its payout ratio?

Short Answer

Expert verified
The payout ratio is 20%.

Step by step solution

01

Calculate Total Financing Requirements

The capital budget needed by Petersen Company is given as \(\$ 1.2\) million. This is the total amount required for financing purposes this year.
02

Determine Equity Portion of Capital Structure

According to the target capital structure, 40% should be financed with equity. Thus, calculate the equity portion needed:\[\text{Equity Portion} = 40\% \times \\( 1.2 \text{ million} = 0.4 \times \\) 1,200,000 = \$ 480,000.\]
03

Calculate Retained Earnings

Since Petersen Company follows a residual dividend policy, calculate retained earnings needed for financing:\[\text{Retained Earnings} = \text{Net Income} - \text{Dividends}.\]
04

Use Residual Dividend Policy to Find Dividends

If the equity requirement is \(\\(480,000\) and net income is \(\\)600,000\), the dividends paid out are the remainder after retained earnings, which must equal the equity requirement:\[\\(480,000 = \\)600,000 - \text{Dividends}\]
05

Solve for Dividends

Rearrange the equation from Step 4 to find the dividends:\[\text{Dividends} = \\(600,000 - \\)480,000 = \$120,000.\]
06

Calculate Payout Ratio

The payout ratio is the proportion of net income that is paid out as dividends. Calculate it as:\[\text{Payout Ratio} = \frac{\text{Dividends}}{\text{Net Income}} = \frac{\\(120,000}{\\)600,000} = 0.2 = 20\%.\]

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Capital Structure
The capital structure of a company reflects the way it finances its overall operations and growth via different sources of funds. It typically includes a mix of debt and equity.
For Petersen Company, the target capital structure is 60% debt and 40% equity. This means that out of the total capital budget of $1.2 million, 60% will be sourced from debt, and the remaining 40% will come from equity.
  • Debt: Borrowing money that needs to be repaid with interest.
  • Equity: Funds from shareholders who own a portion of the company.
The chosen structure plays a crucial role in determining the company's risk and financial health. A higher debt ratio may increase financial risk, but it can also enhance returns during prosperous times, assuming the cost of debt is lower than the return on capital.
Capital Budget
The capital budget is a financial plan for a company's planned capital expenditures. For Petersen Company, this is set at $1.2 million for the year.

Managing a capital budget involves deciding which investments or projects will receive funding. Companies use capital budgets to plan for large investments in assets, like property, infrastructure, or technology, which are essential for growth and profitability.
  • Evaluation: Assessing the profitability and risk of various investment opportunities.
  • Allocation: Deciding which projects will be financed and how much will be allocated.
  • Adjustment: Monitoring financial performance and adjusting budgets as necessary.
Developing an effective capital budget is fundamental to ensuring that a company can afford its investments while managing its financing strategy effectively.
Payout Ratio
The payout ratio indicates the percentage of net income a company distributes to its shareholders in the form of dividends. For Petersen Company, it is 20% under a residual dividend policy.

This ratio helps investors understand how much money is being returned to them vs. how much is kept within the company for growth or debt reduction.
  • Interpretation: A low payout ratio might indicate that the company is reinvesting heavily in growth, while a high payout ratio could suggest mature stability.
  • Calculation: It is calculated as\[\text{Payout Ratio} = \frac{\text{Dividends}}{\text{Net Income}} = \frac{120,000}{600,000} = 20\%.\]
  • Strategy: Companies using a residual dividend policy adjust their dividends based on leftover earnings after funding all projects, aiming for financial flexibility.
The chosen payout ratio affects investor satisfaction and the company's reinvestment capabilities.
Retained Earnings
Retained earnings are the portion of net income that a company retains for reinvestment in its operations, rather than being distributed to shareholders as dividends.

For Petersen Company, retained earnings are calculated by subtracting dividends from net income, resulting in $480,000 retained to support equity financing requirements.
  • Growth: Retaining earnings allows a company to invest in future projects, pay down debt, or engage in share buybacks.
  • Balance: The balance between paying dividends and retaining earnings is crucial for a company to sustain long-term growth.
  • Flexibility: Companies with significant retained earnings have greater flexibility to pursue strategic initiatives without the need to raise additional capital.
Effective management of retained earnings supports operational stability and growth, aligning with the company鈥檚 strategic priorities.

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Most popular questions from this chapter

The Wei Corporation expects next year's net income to be \(\$ 15\) million. The firm's debt ratio is currently 40 percent. Wei has \(\$ 12\) million of profitable investment opportunities, and it wishes to maintain its existing debt ratio. According to the residual dividend model, how large should Wei's dividend payout ratio be next year? Assume the firm uses only debt and common equity in its capital structure.

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 (i.e., 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 impact 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, 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?

Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous-casting process. SSC's founders, Donald Brown and Margo Valencia, had been employed in the research department of a major integrated-steel company, but when that company decided against using the new process (which Brown and Valencia had developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus they own all of the shares. However, SSC has now reached the stage in which outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60 percent equity and 40 percent debt. Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy. Assume that you were recently hired by Arthur Adamson \(\&\) Company \((\mathrm{AA}),\) a national consulting firm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions. a. (1) What is meant by the term "dividend policy"? (2) The terms "irrelevance," "bird-in-the-hand," and "tax preference" have been used to describe three major theories regarding the way dividend policy affects a firm's value. Explain what these terms mean, and briefly describe each theory. (3) What do the three theories indicate regarding the actions management should take with respect to dividend policy? (4) Explain the relationships between dividend policy, stock price, and the cost of equity under each dividend policy theory by constructing two graphs such as those shown in Figure \(14-1 .\) Dividend payout should be placed on the X axis. (5) What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend policy? b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on dividend policy. c. (1) Assume that SSC has an \(\$ 800,000\) capital budget planned for the coming year. You have determined that its present capital structure ( 60 percent equity and 40 percent debt is optimal, and its net income is forecasted at \(\$ 600,000 .\) Use the residual dividend model approach to determine SSC's total dollar dividend and payout ratio. In the process, explain what the residual dividend model is. Then, explain what would happen if net income were forecasted at \(\$ 400,000,\) or at \(\$ 800,000\). (2) In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy? (3) What are the advantages and disadvantages of the residual policy? (Hint: Don't neglect signaling and clientele effects. d. What is a dividend reinvestment plan (DRIP), and how does it work? e. Describe the series of steps that most firms take in setting dividend policy in practice. f. What are stock repurchases? Discuss the advantages and disadvantages of a firm's repurchasing its own shares. g. What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?

Beta Industries has net income of \(\$ 2,000,000\) and it has 1,000,000 shares of common stock outstanding. The company's stock currently trades at \(\$ 32\) a share. Beta is considering a plan in which it will use available cash to repurchase 20 percent of its shares in the open market. The repurchase is expected to have no effect on either net income or the company's P/E ratio. What will be its stock price following the stock repurchase?

Northern Pacific Heating and Cooling Inc. has a 6 -month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 40 percent with a \(\$ 10\) million investment in plant and machinery. The firm wants to maintain a 40 percent debt-to-total- assets ratio in its capital structure; it also wants to maintain its past dividend policy of distributing 45 percent of last year's net income. In 2001 , net income was \(\$ 5\) million. How much external equity must Northern Pacific seek at the beginning of 2002 to expand capacity as desired? Assume the firm uses only debt and common equity in its capital structure.
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