Flavortech Inc. expects EBIT of $2,000,000 for the current year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. For the next year, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual distribution policy (with all distributions in the form of dividends) and has no other projects, what is its expected dividend payout ratio?
A) 100%
B) 60%
C) 40%
D) 20%
E) 0%

Question

Quizplus · Accepted Answer

The firm will use its earnings to fund the project according to its capital structure. With 40% debt and 60% equity, $720,000 (60% of $1,200,000) will be funded by equity. The remaining earnings after funding the project will be distributed as dividends. The dividend payout ratio is the remaining earnings divided by total earnings.