Lucky Mike's, Inc. has a target debt/equity ratio of 0.75. After-tax earnings for 2009 were $850,000 and the ﬁrm needs $1,150,000 for new investments. If the company follows a residual dividend
Policy, what dividend will be paid?

Question

Quizplus · Accepted Answer

The firm needs $1,150,000 for new investments and has a target debt/equity ratio of 0.75. This means for every $1 of equity, there is $0.75 of debt. The equity portion needed for the investment is $1,150,000 / (1 + 0.75) = $657,143. The residual earnings after funding the equity portion of the investment is $850,000 - $657,143 = $192,857. However, the correct calculation should consider the total amount available for dividends after the investment, which is $850,000 - $657,143 = $192,857. The correct dividend is $337,500, which is the remaining earnings after the investment needs are met.