(Dividend policy) A firm has 20 million common shares outstanding. It currently
ID: 2673614 • Letter: #
Question
(Dividend policy) A firm has 20 million common shares outstanding. It currently pays out $1.50 per share per year in cash dividends on its common stock. Historically, its payout ratio has ranged from 30% to 35%. Over the next five years it expects the earnings and discretionary cash flow shown below in millions.o Over the five-year period, what is the maximum overall payout ratio the firm could achieve without triggering a securities issue?
o Recommend a reasonable dividend policy for paying out discretionary cash flow in years 1 through 5.
1 2 3 4 5 Thereafter
Earnings 100 125 150 120 140 150+ per year
Discretionary cash flow 50 70 60 20 15 50+ per year
Explanation / Answer
Total discretionary cash flow = $50 + $70 + $60 + $20 + $15 = $215
Total earnings = $100 + $125 + $150 + $120 + $140 = $635
Maximum Payout Ratio = $215 / $635 = 33.86%
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Current dividend = $1.50 x 20 million shares = $30 million
The firm could gradually increase the dividend from $30 million to $50 million.
D1 = $35 / 20 = $1.75
D2 = $39 / 20 = $1.95
D3 = $43 / 20 = $2.15
D4 = $48 / 20 = $2.40
D5 = $50 / 20 = $2.50
Note that $35 + $39 + $43 + $48 + $50 = $215,
the total discretionary cash flow and since large discretionary cash flows occur at the beginning, there is never a discretionary cash deficit.
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