A Ltd has made a profit of Rs.1, 20,000. Its gearing ratio is 0.4 which is to be maintained. It cost
of capital is: debt 10%, equity 22%, retained earnings 20%. Four projects are under
consideration.
Investment Required Rate of Return on Investment
A Rs.60, 000 19%
B Rs.50, 000 18%
C Rs.80, 000 17%
D Rs.20, 000 16%
What amount should be paid as dividend?
To calculate the amount that should be paid as dividend, we need to determine the amount of profit available for distribution.
1. Calculate the equity and debt components of the company's capital structure:
Total capital = Debt + Equity + Retained Earnings
Given that the gearing ratio (debt to total capital) is 0.4, we can determine the equity as follows:
Equity = Total capital × (1 - Gearing ratio)
Debt = Total capital × Gearing ratio
Let's calculate the equity and debt:
Equity = Rs.1,20,000 × (1 - 0.4) = Rs.1,20,000 × 0.6 = Rs.72,000
Debt = Rs.1,20,000 × 0.4 = Rs.48,000
2. Calculate the cost of debt and equity:
Cost of Debt = Debt × Interest Rate
Cost of Equity = Equity × Rate of Return
Given that the cost of capital for debt is 10%, equity is 22%, and retained earnings is 20%, we can calculate the cost of debt and equity:
Cost of Debt = Rs.48,000 × 0.10 = Rs.4,800
Cost of Equity = Rs.72,000 × 0.22 = Rs.15,840
3. Calculate the total cost of capital:
Total Cost of Capital = Cost of Debt + Cost of Equity + Cost of Retained Earnings
Since the retained earnings are not mentioned for each project, we assume it is distributed evenly among the projects. Therefore:
Cost of Retained Earnings = (Total cost of capital - Cost of Debt - Cost of Equity) / Number of projects
Number of projects = 4
Total Cost of Capital = Rs.4,800 + Rs.15,840 + (Rs.1,20,000 × 0.20) / 4
= Rs.4,800 + Rs.15,840 + Rs.6,000
= Rs.26,640 + Rs.6,000
= Rs.32,640
4. Calculate the retained earnings for each project:
Retained Earnings = Investment Required × Rate of Return - Cost of Capital
Let's calculate the retained earnings for each project:
For project A:
Retained Earnings for A = Rs.60,000 × 0.19 - Rs.32,640 = Rs.11,400 - Rs.32,640 = -Rs.21,240 (Negative value indicates a loss. No dividend can be paid from a loss.)
For project B:
Retained Earnings for B = Rs.50,000 × 0.18 - Rs.32,640 = Rs.9,000 - Rs.32,640 = -Rs.23,640 (Negative value indicates a loss. No dividend can be paid from a loss.)
For project C:
Retained Earnings for C = Rs.80,000 × 0.17 - Rs.32,640 = Rs.13,600 - Rs.32,640 = -Rs.19,040 (Negative value indicates a loss. No dividend can be paid from a loss.)
For project D:
Retained Earnings for D = Rs.20,000 × 0.16 - Rs.32,640 = Rs.3,200 - Rs.32,640 = -Rs.29,440 (Negative value indicates a loss. No dividend can be paid from a loss.)
5. Calculate the total retained earnings:
Total Retained Earnings = Sum of Retained Earnings for all projects
Total Retained Earnings = -Rs.21,240 + -Rs.23,640 + -Rs.19,040 + -Rs.29,440 = -Rs.93,360
As the total retained earnings are negative, it indicates that the company has incurred a loss. Therefore, no dividend can be paid.