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Alternative Dividend Policy

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In 2008 the Keenan Company paid dividends $3.6 million on net income of $10.8 million. The year was normal, and for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2009, earnings are expected to jump to $14.4 million, and the firm expects to have profitable investments opportunities of $8.4 million. It is predictable that Keenan will not be able to maintain the 2009 level of earnings growth - the high 2009 earning level is attributable to an exceptionally profitable new product line introduced that year- and the company will return to its previous 10% growth rate. Keenan's target debt ratio is 40%.

a. calculate Keenan's total dividends for 2009 if it follows each of the following policies:

1. Its 2009 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
2. It continues the 2008 dividend payout ratio.
3. It uses a pure residual policy with all distributions in the form of dividends (40% of the $8.4 million investment is financed with debt).
4. It employs a regular-dividend-plus extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.

b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer.
c. Does a 2009 dividend of $9 million seem reasonable in view of your answers to a and b? If not, should the dividends be higher or lower?

The answers to questions a are
1 $3,960,000
2 $4,800,000
3 $9,360,000
4 Regular= $3,960,000
Extra= $5,400,000

I need to show the work. Show formulas used.

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Solution Preview


Question A1
3,600,000 x (1 + 10%) = 3,960,000

Question A2
3,600,000 / 10,800,000 x 14,400,000 = 4,800,000

Question A3
14,400,000 - ...

Solution Summary

Alternative dividend policies are examined.

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Dividend Policy Problems

Recall that Miller Modigliani 1961 on dividends says they are not relevant to firm value if the firm's target debt/equity ratio is fixed and investments do not change. What if we change investments or capital structure? Then, dividends could alter firm value to the shareholders.

Assume the Base Case Firm has 100 shares at $20 and the following balance sheet:
Cash $1500 Debt $0 Equity $2000 WACC =10% ( Ke )
Dividends Declared $1000, old cash flow is $200 a year perpetuity.

1)Find the equity beta and the per share dividend payment (assume 1 time annual).

Market info:
Rf = 4% RP = 6% Tax = 34%

Firm is considering an investment that generates an additional cash flow of $300 yearly and costs $1500.

2)Value the firm assuming all cash flows are perpetuities in a perfect market.

Perfect Markets Conditions
Lend and Borrow at same rate, rf. No transactions. No taxes. Same info.

3)Show the value of the firm and per share value for the alternatives below.

Firm can cancel its dividend and invest in the project.
Firm can pay out its dividend and not invest in the project.
Firm can pay out its dividend and borrow to invest in the project.
Firm can pay out its dividend and sell stock to invest in the project.

In a perfect market, dividends are not taxed and investment doesn't change.

Repeat your analysis for corporate taxes of 34% and a personal tax rate of 20% considering federal and state income taxes.
Summarize your results in a table. Assume the cash flows in the second analysis are still $200 old and $300 additional even though they would really be CF X ( 1 - tax ).

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