Lane Industries is considering three independent projects, each of which require

Question

Lane Industries is considering three independent projects, each of which requires a $2.9 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here:

Project H (high risk):

Cost of capital = 16%

IRR = 18%

Project M (medium risk):

Cost of capital = 10%

IRR = 8%

Project L (low risk):

Cost of capital = 8%

IRR = 9%

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 $3,800,000. If Lane establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to 2 decimal places.

Project H (high risk):

Cost of capital = 16%

IRR = 18%

Project M (medium risk):

Cost of capital = 10%

IRR = 8%

Project L (low risk):

Cost of capital = 8%

IRR = 9%

Explanation / Answer

In the given case, Lander will accept projects which have IRR greater than the cost of capital. Therefore, Project H and Project L will be accepted requiring a total capital budget of $5,800,000 (2,900,000*2). Out of this total capital budget, 60% will have to be equity. Therefore, the required equity will be $3,480,000 (5,800,000*60%).

The value of dividend payout ratio is determined as follows:

Total Value of Dividends = Net Income - Required Equity = 3,800,000 - 3,480,000 = $320,000

Dividend Payout Ratio = Total Value of Dividends/Net Income*100 = 320,000/3,800,000*100 = 8.42% (answer)

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