The HighT Company is a manufacturer of electronic products. The company is preparing a financial plan for the coming year and has the following independent projects under consideration:
Project
Initial investment ($ millions)
Internal rate of return (%)
A
220
20
B
380
11
C
300
15
D
200
19
E
215
8
Assume these projects have the same risk as the overall company and the cost of capital, which is 12%. HighT predicts that earnings in the coming year will be $234 million. The company has 12 million shares outstanding, and maintains a debt-equity ratio of three.
a Determine HighT’s total planned capital expenditure for the coming year. Explain your answer. (8 marks)
b Suppose the company follows a residual dividend policy. What will the dividend per share be? (8 marks)
c What are the major advantages and disadvantages of a strict residual dividend policy? How does a compromise policy differ from a strict residual policy? (9 marks
a) To determine HighT's total planned capital expenditure for the coming year, we need to calculate the total initial investment for each project and compare it to the company's available funds.
The total planned capital expenditure can be calculated by summing up the initial investments for all the projects. In this case, the initial investments are as follows:
Project A: $220 million
Project B: $380 million
Project C: $300 million
Project D: $200 million
Project E: $215 million
Total planned capital expenditure = $220 + $380 + $300 + $200 + $215 = $1,315 million
Therefore, HighT's total planned capital expenditure for the coming year is $1,315 million.
b) A residual dividend policy means that the company will pay dividends using any remaining funds after financing all investment opportunities. To calculate the dividend per share, we need to find the amount available for dividends.
First, we need to calculate the earnings available for dividends. The predicted earnings for the coming year are $234 million.
Earnings available for dividends = Predicted earnings - Total planned capital expenditure
Earnings available for dividends = $234 million - $1,315 million = -$1,081 million
Since the earnings available for dividends are negative, it means there are not enough funds to pay dividends. Therefore, HighT would not be able to distribute dividends per share under the residual dividend policy.
c) The strict residual dividend policy refers to a policy where all available funds are used for investment purposes and no dividends are paid. The major advantage of this policy is that it allows the company to reinvest its earnings into profitable projects, which can potentially increase the future value of the company.
However, the strict residual dividend policy has a major disadvantage of not providing any regular income to shareholders in the form of dividends. This may discourage investors who rely on dividends for income or prefer regular cash flow.
On the other hand, a compromise dividend policy allows the company to strike a balance between reinvestment and returning earnings to shareholders in the form of dividends. Under a compromise policy, the company sets a target dividend payout ratio (e.g., 40%) and pays dividends accordingly, while the remaining earnings are reinvested.
The compromise dividend policy provides both regular income to shareholders and funds for reinvestment, which can attract investors who value both income and growth potential.
In summary, a strict residual dividend policy prioritizes reinvestment at the expense of regular dividends, while a compromise policy aims to strike a balance between dividends and reinvestment. The choice of dividend policy depends on factors such as the company's growth prospects, cash flow requirements, and investor preferences.