Reading 33- LOS j ～ Q1－5

1.Which of the following dividend policies would a firm with temporary excess cash flows most likely use? A share repurchase program:

A)   and no payout of dividends.

B)   and a growing dividend model.

C)   in conjunction with a residual dividend model.

D)   and a stock split program.

Click for Answer and Explanation C)

The residual dividend model allows firms to pay out dividends only if more earnings are available than are needed to support the optimal capital budget. Because dividend payouts can be unstable, a firm can supplement a low, stable dividend with a share repurchase program or with an extra dividend when times are good. Stock repurchases allow management to distribute cash without signaling information about future earnings. Abnormally good years could be followed with the purchase of shares, while selling shares would provide liquidity during temporary cash shortages.

2.Under the residual dividend model, firms would do all of the following EXCEPT:

A)   borrow money to maintain the dividend payout schedule.

B)   determine their optimal capital budgets.

C)   determine the amount of equity needed to meet the capital budget.

D)   pay dividends only if more earnings are available than needed to support the optimal capital budget.

Click for Answer and Explanation A)

Under the residual dividend model the optimal dividend payout is a function of four factors: investors' preferences for dividends vs. capital gains, the firm’s investment opportunity schedule (IOS), the firm’s target capital structure, and the availability and cost of external capital to the firm. The firm will pay dividends only if more earnings are available than are needed to support the optimal capital budget.

3.Stargell Industries follows a strict residual dividend policy. The company has a capital budget of $3,000,000. It has a target capital structure that consists of 30 percent debt and 70 percent equity. The company forecasts that its net income will be $3,500,000. What will be the company's expected dividend payout ratio this year?

A)   40%.

B)   35%.

C)   30%.

D)   25%.

Click for Answer and Explanation A)

In order to maintain the optimal capital structure, new projects will be financed with the same mix of debt and equity. Therefore, if the capital budget is $3,000,000 for next year the equity portion will be 70% of $3,000,000 or $2,100,000. The remainder will be financed with debt. If Net Income is $3,500,000 then dividends will be $1,400,000. (Dividends = Net Income – Retained Earnings = $3,500,000 - $2,100,000). The dividend payout ratio is equal to dividends divided by net income. $1,400,000 / $3,500,000 = 0.40 or 40%.

4.Tina Donaldson is the Chief Financial Officer for Outback Supply Corporation (OSC). OSC is considering revising its dividend payout policy and Donaldson has been asked by the board of directors to suggest alternatives for the board to consider. Donaldson prepares a memo listing the benefits of a residual dividend model. The memo includes three key points:

Point 1: A residual dividend policy is simple for the company to use and easy to implement.

Point 2: The residual dividend approach allows management to determine investment opportunities without having to take dividends into consideration.

Point 3: Because the firm is maximizing its positive net present value opportunities with a residual dividend model, investors are likely to perceive the firm as having less risk.

Which of Donaldson’s points describing advantages of the residual dividend approach are most accurate?

A)   Points 1, 2, and 3.

B)   Points 1 and 2 only.

C)   Points 2 and 3 only.

D)   Point 2 only.

Click for Answer and Explanation B)

The residual dividend approach is easy for a company to use and implement – the company simply reinvests earnings needed to maintain and grow the business, and pays out any left over earnings out as dividends. The residual dividend approach also allows management to determine investment opportunities without having to take dividends into consideration. Note that the residual dividend approach is likely to lead to dividends that fluctuate dramatically from year to year. Since investors prefer stable dividends, they are likely to perceive a firm following a residual dividend approach as having greater risk, which is one of the disadvantages of the approach.

5.The following financial data relates to the Carmichael Beverage Company for 2005:

§ The target capital structure is 65% equity and 35% debt.

§ After-tax cost of debt is 7 percent.

§ Cost of retained earnings is estimated to be 12 percent.

§ Cost of equity is estimated to be 13.5% if the company issues new common stock.

§ Net income is $4,000,000

Carmichael Beverage Company is considering the following investment projects:

Project A: $2,500,000 value; IRR of 11.50%
Project B: $1,000,000 value; IRR of 13.00%
Project C: $2,000,000 value; IRR of 9.50%
Project D: $500,000 value; IRR of 10.50%
Project E: $1,500,000 value; IRR of 8.00%

If the company follows a residual dividend policy, its payout ratio will be closest to:

A)   12%.

B)   35%.

C)   25%.

D)   0%.

Click for Answer and Explanation B)

First determine the WACC. WACC = w_d × k_d(1 - t) + w_e × k_s, where k_s is the required return on retained earnings. WACC = (0.65)(0.12) + (0.35)(0.07) = 0.078 + 0.0245 = 0.1025 = 10.25%. Second, decide to accept projects A, B, and D since they are all greater than the WACC. Accepting these projects will result in a total capital budget of ($2,500,000 + $1,000,000 + $500,000) = $4,000,000. The equity portion is 65% x 4,000,000 = $2,600,000. From Carmichael’s net income, $4,000,000 - $2,600,000 = $1,400,000 will be left over for dividends, which implies a payout ratio of $1,400,000/$4,000,000 = 35 percent.