Peterson Company expects earnings per share and dividends per share to be $4.50 and $2.50, respectively, next year. Peterson currently has 5,000,000 shares of common stock outstanding. The company's capital budget for next year is projected to be $25,000,000. Peterson plans to maintain its present debt ratio (debt to total assets) at 40% next year. (Assume that Peterson's capital structure includes only common equity and debt and that these will be the only sources of funds to finance capital budgeting projects next year.) Determine how much external equity the company must raise to finance its capital budget.

Question

Quizplus · Accepted Answer

To determine how much external equity the company must raise, we need to use the retained earnings equation:
Retained Earnings = Net Income - Dividends
Since we know that earnings per share (EPS) is $4.50 and dividends per share (DPS) is $2.50, we can determine the total earnings and dividends for the company:
Total Earnings = EPS x Shares Outstanding = $4.50 x 5,000,000 = $22,500,000
Total Dividends = DPS x Shares Outstanding = $2.50 x 5,000,000 = $12,500,000
Using the retained earnings equation, we can calculate the amount of earnings that will be retained by the company:
Retained Earnings = Net Income - Dividends
Retained Earnings = $22,500,000 - $12,500,000 = $10,000,000
Since Peterson plans to maintain its debt ratio at 40%, we can determine the amount of debt and equity the company will need next year:
Total Assets = Capital Budget / Debt Ratio = $25,000,000 / 0.40 = $62,500,000
Total Debt = Total Assets x Debt Ratio = $62,500,000 x 0.40 = $25,000,000
Total Equity = Total Assets - Total Debt = $62,500,000 - $25,000,000 = $37,500,000
Since Peterson currently has $27,500,000 in equity ($5,000,000 shares outstanding x $4.50 EPS), the company will need to raise an additional amount of external equity to finance its capital budget:
External Equity = Total Equity - Retained Earnings - Current Equity
External Equity = $37,500,000 - $10,000,000 - $27,500,000 = $0
Therefore, the answer is (C) $5,000,00.

Peterson Company Expects Earnings Per Share and Dividends Per Share