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% while the cost of new equity is 16%. Assuming Wagner has $90 million of investment projects having expected returns greater than 16%, determine Wagner's dividend and investment policies.
A) Pay out $20 million in dividends and raise $30 million externally
B) Pay no dividends and invest only in the first $80 million in projects.
C) Pay out $10 million in dividends and raise $20 million externally
D) Pay no dividends and raise $10 million externally

Question

Quizplus · Accepted Answer

Under a pure residual dividend policy, dividends are paid only after all profitable investment opportunities are funded. Wagner has $80 million in earnings and $90 million in projects with returns greater than 16%. Therefore, they will use all $80 million of earnings for investment and raise an additional $10 million externally, paying no dividends.

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