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Detailed Explanation to Residual Dividend Policy

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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?

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Solution Summary

The solution explains various calculations under a residual dividend policy using simple and concise explanations and equations.

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a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?

The amount of equity needed for investment is 60%. The investment is $10 million, so the equity needed is $6 million.
Net Income is $8 million. Under the residual dividend model retained earnings needed will be $6 million.

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?

The amount of dividends will be $2 million( $ 8 million in net income and $6 million needed for the projects). Number of share are 1,000,000. The Dividend per share is 2,000,000/1,000,000=$2.

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?

Total dividends = 1,000,000X3 = ...

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