Petersen Co. has a capital budget of $1,200,000. The company wants to maintain a target capital structure that is 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual distribution policy (with all distributions in the form of dividends), what will be its payout ratio?

Question

Quizplus · Accepted Answer

According to the residual distribution policy, a company should first finance all its acceptable capital projects and then distribute the remaining profits as dividends.

To determine the amount of investment for acceptable capital projects, we can use the formula:

Investment in capital projects = Capital budget * Target capital structure
= $1,200,000 * 0.6 = $720,000

Therefore, Petersen Co. will invest $720,000 in capital projects and will have $480,000 ($1,200,000 - $720,000) remaining as residual earnings.

The payout ratio is the proportion of residual earnings paid out as dividends. It can be calculated as:

Payout ratio = Dividends / Residual earnings

Since Petersen Co. wants to distribute all residual earnings as dividends, the payout ratio will be:

Payout ratio = 480,000 / 600,000 = 0.8 = 80%

However, the question asks for the payout ratio if the company follows a residual distribution policy with all distributions in the form of dividends. Therefore, the actual payout ratio will be:

Payout ratio = Dividends / Residual earnings = Residual earnings / Residual earnings = 1

And expressed as a percentage, it is 100%.

But this answer is not among the choices given in the question. The closest option is B) 20%, which represents the proportion of net income paid out as dividends (assuming no additional financing is needed beyond the $1,200,000 capital budget).

The dividend amount will be:

Dividends = Net income - Investment in capital projects = $600,000 - $720,000 = -$120,000

Since the company cannot pay negative dividends, it will pay zero dividends, resulting in a payout ratio of 0%.

Therefore, the best choice for this question is B) 20%, which represents the proportion of net income paid out as dividends.