The Wagner Company tries to follow a pure "residual" dividend policy. Earnings and dividends last year were $100 million and $20 million, respectively. Anticipated earnings for this year are $80 million. The company is financed completely with common equity. The required rate of return on retained earnings is 15% and the cost of new equity is 16%. Assuming Wagner has $70 million of investment projects having expected returns greater than 15%, determine the total amount of dividends Wagner should pay.
A) None
B) $10 million
C) $20 million in dividends and raise needed investment funds externally
D) $80 million in dividends and raise needed investment funds externally

Question

Quizplus · Accepted Answer

A pure residual dividend policy means the company pays dividends from the leftover or "residual" earnings after funding all projects with positive net present values (NPVs) that meet or exceed the hurdle rate (in this case, 15%). Wagner has $70 million of investment projects with expected returns greater than 15%, which it should fund internally given its cost of retained earnings is 15%. With anticipated earnings of $80 million, after investing the $70 million, Wagner would have $10 million left, which should be paid out as dividends.

The Wagner Company Tries to Follow a Pure "Residual" Dividend