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?
a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?
Capital budget = $10,000,000; Capital structure = 60% equity, 40% debt;
Common shares outstanding = 1,000,000.
Retained earnings needed = $10,000,000(0.6) = $6,000,000.
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?
According to the residual dividend model, only $2 million is available for dividends.
NI - Retained earnings needed for capital projects = Residual dividend
$8,000,000 - $6,000,000 = $2,000,000.
DPS = $2,000,000/1,000,000 = $2.00.
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?
Retained earnings available = $8,000,000 - $3.00(1,000,000)
Retained earnings available = $5,000,000.
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?
No. If the company maintains its $3.00 DPS, only $5 million of retained earnings will be available for capital projects. However, if the firm is to maintain its current capital structure $6 million of equity is required. This would necessitate the company having to issue $1 million of 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?
Capital budget = $10 million; Dividends = $3 million; NI = $8 million;
Capital structure = ?
RE available = $8,000,000 - $3,000,000 = $5,000,000.
Percentage of capital budget financed with RE = $10,000,00
$5,000,000
= 50%.
Percentage of capital budget financed with debt = $10,000,00
$5,000,000
= 50%
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?
Dividends = $3 million; Capital budget = $10 million; 60% equity, 40% debt; NI = $8 million.
Equity needed = $10,000,000(0.6) = $6,000.000.
RE available = $8,000,000 - $3.00(1,000,000) = $5,000,000.
External (New) equity needed = $6,000,000 - $5,000,000
= $1,000,000.
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?
Dividends = $3 million; NI = $8 million; Capital structure = 60% equity, 40% debt.
RE available = $8,000,000 - $3,000,000 = 5,000,000.
We’re forcing the RE available = Required equity to fund the new capital budget.
Required equity = Capital budget (Target equity ratio)
$5,000,000 = Capital budget (0.6)
Capital budget = $8,333,333.
Therefore, if Buena Terra cuts its capital budget from $10 million to $8.33 million, it can maintain its $3.00 DPS, its current capital structure, and still follow the residual dividend policy.
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?
The firm can do one of four things:
(1) Cut dividends.
(2) Change capital structure, that is, use more debt.
(3) Cut its capital budget.
(4) Issue new common stock.
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14.1 %
12 million before tax
331.89
Could you please set up the equations?
Fifteen years ago, Roop Industries sold $400 millions of convertible bonds. The bonds had a 40 year maturity, a 5.75 % coupon rate, and paid interest annually. They were sold at their $1,000 par value. The conversion price was set at $62.75; the common stock price was $55 per share. The bonds were subordinated debentures, and they were given an A rating; straight nonconvertible debentures of the same qualify yielded about 8.75% at the time Roop's bonds were issued
a. If Buena Terra follows the residual dividend model, it will distribute all of its earnings as dividends until the retained earnings are exhausted. Therefore, the retained earnings needed to fund its capital budget will be $10 million.
b. If Buena Terra follows the residual dividend model, the dividend per share (DPS) will be the total dividend amount divided by the number of outstanding shares. Since the company has 1,000,000 shares of common equity outstanding and the dividend is expected to remain constant at $3.00, the DPS will also be $3.00. The payout ratio is the DPS divided by the earnings per share (EPS), which can be calculated by dividing the company's net income by the number of outstanding shares. The EPS is $8 million divided by 1,000,000 shares, which is $8. Therefore, the payout ratio will be $3.00 divided by $8, which is 37.5%.
c. If Buena Terra maintains its current $3.00 DPS for the next year, the retained earnings available for the firm's capital budget will be its net income minus the dividend paid. Since the net income is $8 million and the dividend paid is $3.00 per share multiplied by 1,000,000 shares (which is $3,000,000), the retained earnings available will be $8 million minus $3 million, which is $5 million.
d. No, the company cannot maintain its current capital structure, maintain the $3.00 DPS, and maintain a $10 million capital budget without having to raise new common stock. In order to fund the full $10 million capital budget, the company would require more retained earnings or additional funding sources such as debt or issuing new common stock.
e. If the company wants to maintain the $3.00 DPS and the $10 million capital budget, and is willing to issue more debt, the portion of the capital budget that would have to be financed with debt depends on the availability of retained earnings. If we assume that the retained earnings available are $5 million (as calculated in part c), then the remaining capital budget that needs to be financed with debt would be $10 million minus $5 million, which is $5 million.
f. If the company wants to maintain the $3.00 DPS, the target capital structure, and the $10 million capital budget, and is also committed to issuing new common stock, the minimum dollar amount of new common stock that the company would have to issue would depend on the availability of retained earnings. If we assume that the retained earnings available are $5 million (as calculated in part c), then the remaining capital budget that needs to be financed would be $10 million minus $5 million, which is $5 million. Since the target capital structure is 60% equity and 40% debt, the portion of the capital budget that needs to be financed with equity (new common stock) would be 60% of $5 million, which is $3 million.
g. If the company wants to maintain the $3.00 DPS, the target capital structure, and avoid issuing new common stock, it is willing to cut its capital budget to meet its other objectives. Assuming that the company's projects are divisible, the company's capital budget for the next year would be the amount of retained earnings available. If we assume the retained earnings available are $5 million (as calculated in part c), then the company's capital budget for the next year would be $5 million.
h. A firm that follows the residual dividend policy can take several actions when its forecasted retained earnings are less than the retained earnings required to fund its capital budget:
1. Cut dividends: The firm can reduce or eliminate dividends to conserve cash and increase the amount of retained earnings available for the capital budget.
2. Issue debt: The firm can raise funds by issuing debt to finance its capital budget. This would increase the debt component of the capital structure.
3. Issue new common stock: The firm can issue new common stock to raise funds for the capital budget. This would increase the equity component of the capital structure.
4. Cut or delay projects: The firm can cut or delay some projects in the capital budget to reduce the funding requirement.
5. Seek external financing: The firm can explore other sources of financing, such as venture capital or loans from financial institutions, to fund its capital budget.
To answer the given questions related to the residual dividend model, we need to understand a few key concepts and calculations.
1. Retained Earnings (RE): This represents the portion of a company's net income that is not paid out as dividends, but retained for reinvestment.
2. Dividend Per Share (DPS): This is the amount of dividend paid per outstanding share of common equity.
3. Payout Ratio: This is the proportion of earnings paid out as dividends, calculated as DPS divided by Earnings Per Share (EPS).
4. Capital Budget: The total amount of funds required for investment in projects by the company.
Now let's proceed with answering each question step by step:
a. To determine the retained earnings needed to fund the capital budget:
Retained Earnings = Net Income - Dividends
Given:
Net Income = $8 million
Dividends = $3.00 DPS * 1,000,000 shares
Therefore, Retained Earnings = $8 million - ($3.00 * 1,000,000) = $5 million
b. To calculate the dividend per share and payout ratio:
Dividend Per Share = DPS = $3.00 (Given)
Payout Ratio = DPS / EPS
We need additional information to calculate EPS. If EPS is provided, substitute its value into the equation.
c. To determine the retained earnings available if the DPS remains $3.00:
Retained Earnings = Net Income - Dividends
Given:
Net Income = $8 million
Dividends = $3.00 DPS * 1,000,000 shares
Therefore, Retained Earnings = $8 million - ($3.00 * 1,000,000) = $5 million
d. To check if the company can maintain its current capital structure, the DPS, and meet the capital budget without raising new common stock:
Calculate the retained earnings available as per part (c). If the available retained earnings equal or exceed the capital budget of $10 million, the company can meet all objectives without issuing new common stock.
e. To determine the portion of the capital budget to be financed with debt:
Since we are assuming a minimal effect on the composite cost of capital, we can allocate the remaining portion of the capital budget after retained earnings to debt financing. Subtract retained earnings ($5 million from part (c)) from the capital budget ($10 million) to find the remaining portion to be financed. The difference ($10 million - $5 million = $5 million) can be financed with debt.
f. To calculate the minimum amount of new common stock to be issued:
Given:
Target Capital Structure = 60% Equity and 40% Debt
Capital Budget = $10 million
Retained Earnings available = $5 million (from part (c))
Let's assume the common stock issuance as "x."
The portion of the capital budget to be financed with equity = (Target Equity %) * Capital Budget - Retained Earnings available
Therefore, (0.60 * $10 million) - $5 million = x
Solve for x to find the minimum amount of new common stock to be issued.
g. To determine the company's capital budget for the next year without issuing new common stock:
If the company wants to maintain the $3.00 DPS and the target capital structure, but avoid issuing new common stock, it will have to reduce the capital budget. The exact amount of reduction depends on the retained earnings available and the portion of the capital budget to be financed from retained earnings.
h. Actions a firm can take when forecasted retained earnings are less than the retained earnings required to fund the capital budget:
- The company can reduce its capital budget by cutting back on projects or postponing them.
- It can explore external financing options, such as borrowing more or issuing new debt.
- The company can also consider increasing the targeted payout ratio to free up more retained earnings for funding the capital budget.
Please note that the calculations in parts b, e, f, and g require additional information that is not provided in the given question. You might need access to the company's financial statements or further details on EPS and the target capital structure to obtain accurate answers.