Your company has decided that its capital budget during the coming year will be

Question

Your company has decided that its capital budget during the coming year will be $20 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) are projected to be $34.667 million for the year. The company has $200 million of assets; its average rate on outstanding debt is 10 percent; and its tax rate is 40 percent. If the company follows the residual distribution policy (with all distributions in the form of dividends) and maintains the same capital structure, what will its dividend payout ratio be? Show step by step your solution.

Explanation / Answer

Amount of debt = 200 million x 40%

                                = 80 million

Interest cost = 80 million x 10%

                         = 8 million

Net Income = (EBIT – interest) x( 1- tax rate)

                        = (34.667 -8)x(1-0.40) million

                       = 16.0002 million

Equity needed = capital budget x equity ratio

                                = 20 million x 60%

                                = 12 million

Dividend payout ratio = (net income – equity needed)/ net income

                                          = (16.0002- 12)/16.0002

                                         = 25%

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