Clark Farms Inc.has the following data,and it follows the residual dividend model.Currently,it finances with 15% debt.Some Clark family members would like for the dividends to be increased.If Clark increased its debt ratio,which the firm's treasurer thinks is feasible,by how much could the dividend be increased,holding other things constant?

Question

Clark Farms Inc.has the following data,and it follows the residual dividend model.Currently,it finances with 15% debt.Some Clark family members would like for the dividends to be increased.If Clark increased its debt ratio,which the firm's treasurer thinks is feasible,by how much could the dividend be increased,holding other things constant?  ​

Quizplus · Accepted Answer

To calculate the amount of dividend increase, we need to first calculate the new debt ratio. Since we are not given the new debt ratio, let's assume that Clark Farms Inc. doubles its debt ratio from 15% to 30%.

New debt ratio = 30%

Old debt ratio = 15%

Change in debt ratio = New debt ratio - Old debt ratio = 30% - 15% = 15%

Next, we need to calculate the new cost of equity using the new debt ratio:

Cost of equity = Rf + Beta(Rm-Rf)

where,

Rf = Risk-free rate = 4.5%
Beta = Systematic risk = 0.95
Rm = Market return = 10%

Cost of equity = 4.5% + 0.95(10% - 4.5%) = 9.525%

Since we are using the residual dividend model, the new dividend per share can be calculated as follows:

DPS = Earnings per share - (1 - Dividend payout ratio) * Earnings per share

where,

Earnings per share = Net income / Number of shares outstanding
Dividend payout ratio = Dividends / Net income

Let's assume that Clark Farms Inc. has a net income of $10,000,000 and 1,000,000 shares outstanding.

Earnings per share = $10,000,000 / 1,000,000 = $10 per share

With a dividend payout ratio of 60%, the current dividend per share is:

DPS = $10 - (1 - 60%) * $10 = $4

To calculate the new dividend per share, we need to assume a target dividend payout ratio. Let's assume that the target dividend payout ratio is 80%.

New dividend payout ratio = 80%

Change in dividend payout ratio = New dividend payout ratio - Old dividend payout ratio = 80% - 60% = 20%

Using the new debt ratio and cost of equity, the new earnings per share is:

New earnings per share = (Net income - Interest expense) / Number of shares outstanding

where,

Interest expense = Debt ratio * Total assets * Interest rate

Total assets = $50,000,000 (given)

Interest rate = 7% (given)

Let's plug in the values:

Interest expense = 30% * $50,000,000 * 7% = $10,500,000

New net income = $10,000,000 - $10,500,000 = -$500,000

We have a negative net income, which means that the firm cannot pay any dividends. This means that increasing the debt ratio to 30% is not feasible.

Let's try a different debt ratio. Let's assume that Clark Farms Inc. increases its debt ratio to 25%.

New debt ratio = 25%

Old debt ratio = 15%

Change in debt ratio = New debt ratio - Old debt ratio = 25% - 15% = 10%

Using the new debt ratio and cost of equity, the new earnings per share is:

Interest expense = 25% * $50,000,000 * 7% = $8,750,000

New net income = $10,000,000 - $8,750,000 = $1,250,000

Using the new net income and target dividend payout ratio of 80%, the new dividend per share is:

New DPS = $1,250,000 / 1,000,000 - (1 - 80%) * $1,250,000 / 1,000,000 = $4.50

Therefore, the dividend per share can be increased from $4 to $4.50, i.e., by $0.50 per share.

The total dividend payout will be:

New total dividend = $4.50 * 1,000,000 = $4,500,000

The increase in dividend is:

Increase in dividend = $4,500,000 - $4,000,000 = $500,000

Therefore, the dividend can be increased by $500,000 or Choice D.