Warren Supply Inc.is evaluating its capital budget.The company finances with debt and common equity, but because of market conditions, wants to avoid issuing any new common stock during the coming year.It is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of stock.Its capital budget is forecasted at $800,000, and it is committed to maintaining a $2.00 dividend per share.Given these constraints, what percentage of the capital budget must be financed with debt?

Question

Quizplus · Accepted Answer

To determine the percentage of the capital budget that must be financed with debt, first calculate the total equity available for the capital budget. The company plans to maintain a $2.00 dividend per share on its 500,000 shares, which totals $1,000,000 in dividends. However, the forecasted EPS is $3.00 on the same number of shares, indicating a total earnings of $1,500,000. The difference between total earnings and dividends ($1,500,000 - $1,000,000 = $500,000) represents the equity available for the capital budget. Since the capital budget is $800,000 and only $500,000 can be financed with equity, the remaining $300,000 must be financed with debt. Therefore, the percentage of the capital budget financed with debt is ($300,000 / $800,000) * 100% = 37.50%.