Your company has decided that its capital budget during the coming year will be $20 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) are projected to be $34.667 million for the year. The company has $200 million of assets; its average interest rate on outstanding debt is 10 percent; and its tax rate is 40 percent. If the company follows the residual distribution policy (with all distributions in the form of dividends) and maintains the same capital structure, what will its dividend payout ratio be?

Question

Quizplus · Accepted Answer

First, we need to calculate the amount of debt and equity that the company will have:

Debt = 0.4 x $200 million = $80 million
Equity = 0.6 x $200 million = $120 million

Next, we need to calculate the interest expense on the debt:

Interest expense = 0.1 x $80 million = $8 million

Next, we need to calculate the earnings available for distribution (EAD):

Earnings available for distribution (EAD) = EBIT - interest expense x (1 - tax rate)
EAD = $34.667 million - $8 million x (1 - 0.4)
EAD = $34.667 million - $4.8 million
EAD = $29.867 million

Finally, we can calculate the dividend payout ratio:

Dividend payout ratio = Dividends / EAD
Dividend payout ratio = $20 million / $29.867 million
Dividend payout ratio = 0.6687

So, the dividend payout ratio is approximately 25% (0.6687 x 100%). Therefore, the best choice is C) 25%.

Your Company Has Decided That Its Capital Budget During the Coming