Question

A1 Enterprises is considering the following the following three independent projects ranked according to their risk, cost of capital and internal rate of return (IRR):Note that the projects’ costs of capital vary because the projects have different levels of risk. The company’s optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of $5,000,000. If A1 establishes its dividends from the residual dividend model, what will be its payout ratio?

Answer 1

Answer:

In the question, investment to be made in new project is not given. Therefore it is assumed that $4,000,000 will be invested in the new project;

Explanation:

Debt Financing= $4,000,000*40%=$1,600,000

Equity Financing=$4,000,000*60%=$2,400,000

Residual Dividend formula=Net income-Equity financing

Residual dividend=$5,000,000-$2,400,000=$2,600,000

Therefore $2,600,000 will be paid as dividends if the required new investment are $4,000,000.

In case of different new investment amount, we can easily work out the revised figures through above formulas.

Answer 2

Answer: Please refer to the explanation section

Explanation:

The question is incomplete. The amount that A1 Enterprises wants to invest in new projects is not provided in the question. We will provide an assumed amounts in order to clearly illustrate how to approach questions of this nature.

Residual Dividend Model

Residual Dividend Model is a Dividends Payout Policy or method that companies may use in determining the amount of earnings that will be distributed to the Shareholders of the company (dividends). Companies using this model prefer Financing all their project using earnings.

When a Company uses Residual Dividend Model reinvestment of earnings takes priority. The company will identify projects and determine the amount of funds needed to finance new projects. The company will then use earning to finance new projects than the remainder of the earnings amount will be paid to shareholders.

Residual Dividend Model Method assumes that shareholders perceives Capital Gains and Share Dividends to be of the same value meaning Shareholders do not care whether they receive dividends or capital gains as long as they bring the same value. This assumptions is the reason market value is immune to the decision to reinvest earnings first before paying dividends. The Market Value is not affected because Shareholders considers share holders and dividends to be equal in Value.

Let us assume A1 Enterprises wishes to invent $3000 000 in the new projects.

Net Income or Earnings after tax =$5000 000

Earnings to be distributed as dividends = $5000 000 - $3000 000

Earnings to be distributed as dividends = $2000 000

Dividends Pay out Ratio = $2000 000/$5000 000

Dividends Pay out Ratio = 0.4 = 40%

When A1 enterprises uses earnings to finance new projects, The payout Ratio is 40% if we assume the A1 enterprises wants to invest $3000 000 in new projects.