Residual Distribution Policy Harris Company must set its investment and dividend

Question

Residual Distribution Policy

Harris Company must set its investment and dividend policies for the coming year. It has three independent projects from which to choose, each of which requires a $3 million investment. These projects have different levels of risk, and therefore different costs of capital. Their projected IRRs and costs of capital are as follows:

Harris intends to maintain its 25% debt and 75% common equity capital structure, and its net income is expected to be $7,570,500. If Harris maintains its residual dividend policy (with all distributions in the form of dividends), what will its payout ratio be? Round your answer to two decimal places.

Project A: Cost of capital = 16%; IRR = 19% Project B: Cost of capital = 11%; IRR = 14% Project C: Cost of capital = 9%;  IRR = 7%

Explanation / Answer

Dividend payment under residual policy = 7570500 - 3000000 * .75 - 3000000 * .75 = 3070500

Payout ratio = 3070500 / 7570500 = 40.56%

Note:

Project C will be rejected as it has IRR lower than cost of capital.

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