A firm projects next year's after-tax earnings at $500,000, and proposes spending $800,000 on new capital budgeting projects. The target capital structure is 50% debt and 50% equity. What dividend payout ratio would be appropriate if the firm adheres strictly to a residual dividend policy?

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Since the company follows a residual dividend policy, it will first utilize the funds for capital budgeting and then pay dividends to the shareholders from the residual earnings. The total capital budget is $800,000, to be financed at a 50-50 debt to equity ratio, therefore, the equity funding required is 50% of $800,000, which is $400,000. Hence, the amount of residual earnings available for dividend payment is $500,000 - $400,000 = $100,000. If the firm wants to maintain a dividend payout ratio of X, then the dividend amount would be X% of $100,000 = $1000X. However, we know that the amount for dividend payout cannot be greater than the residual earnings of $100,000. Therefore, we can write the equation as $1000X ≤ $100,000, which gives X ≤ 100. Hence, the maximum dividend payout ratio that can be supported is 20% (i.e., $1000X = $100,000, or X = 100, but X ≤ 20 to meet the feasibility condition). Therefore, the appropriate dividend payout ratio would be 20.0%.

A Firm Projects Next Year's After-Tax Earnings at $500,000, and Proposes