Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and she also wants to pay a dividend of $500,000. If the company follows the residual dividend model, how much income must it earn, and what will its dividend payout ratio be?

Question

Quizplus · Accepted Answer

Step 1: Calculate the amount of funding needed from retained earnings:

Total capital budget = $725,000
Target debt ratio = 45%
Target equity ratio = 55%

Total equity needed = Total capital budget * Target equity ratio = $725,000 * 55% = $398,750

Total debt needed = Total capital budget * Target debt ratio = $725,000 * 45% = $326,250

Total funding needed = Total equity needed + Total debt needed = $398,750 + $326,250 = $725,000

Amount of funding available from retained earnings = Net income - Dividends paid

Step 2: Calculate the minimum net income needed to fund the capital budget and pay the dividend:

Dividend = $500,000

Net income = Retained earnings + Dividend
Net income = Funding needed - Retained earnings + Dividend
Net income = $725,000 - Retained earnings + $500,000
Net income = $1,225,000 - Retained earnings

Since the company is using the residual dividend model, it will pay out all available earnings after funding its capital budget and paying dividends. Therefore, the net income needed to fund the capital budget and pay the dividend is equal to the amount of funding needed.

Net income needed = $725,000

Step 3: Calculate the dividend payout ratio:

Dividend payout ratio = Dividend / Net income
Dividend payout ratio = $500,000 / $898,750
Dividend payout ratio = 55.63%

Paul Inc Forecasts a Capital Budget of $725,000