Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants to maintain a target capital structure with 30% debt and 70% equity, and its forecasted net income is $400,000. If the company follows the residual dividend policy, how much in dividends, if any, will it pay?

Question

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According to the residual dividend policy, dividends are paid out of the leftover or residual earnings after funding all the positive net present value (NPV) projects. Since the capital budget is $500,000, the maximum amount of funds that can be spent on projects is $500,000. The company's target capital structure is 30% debt and 70% equity, which means that the company plans to finance its projects with 30% debt and 70% equity.

The total amount of funds available through equity is 70% of the capital budget, or $350,000 (70% × $500,000). The remaining amount of funds available through debt is 30% of the capital budget, or $150,000 (30% × $500,000).

To calculate the amount of funds that can be distributed as dividends, we need to calculate the amount of funds that will be required to finance all the positive NPV projects. Suppose the company has identified $450,000 in positive NPV projects. Since the company only has $500,000 in available funds, it will fund all $450,000 of these projects. Therefore, $50,000 ($500,000 - $450,000) is leftover and available for dividends.

Since the company plans to maintain a target capital structure of 30% debt and 70% equity, it will need to use $150,000 in debt funding for its capital budget. The remaining $350,000 will be financed through equity. The interest expense on $150,000 of debt can be calculated by multiplying the debt amount by the interest rate. Suppose the interest rate is 6%. Therefore, the interest expense on $150,000 of debt would be $9,000 ($150,000 × 6%).

Finally, we can calculate the amount of dividends that the company can distribute by subtracting the interest expense from the available funds. Therefore, the amount of dividends that Mortal Inc. can distribute is $41,000 ($50,000 - $9,000). Similarly, if we round up, the answer will be $50,000.