Your company has decided that its capital budget during the coming year will be $20 million.Its optimal capital structure is 60 percent equity and 40 percent debt.Its earnings before interest and taxes (EBIT)are projected to be $34.667 million for the year.The company has $200 million of assets;its average interest rate on outstanding debt is 10 percent;and its tax rate is 40 percent.If the company follows the residual dividend policy and maintains the same capital structure,what will its dividend payout ratio be?
A) 15%
B) 20%
C) 25%
D) 30%
E) 35%

Question

Quizplus · Accepted Answer

First, we need to calculate the amount of net income available to distribute as dividends.

EBIT - Interest Expense = Earnings Before Taxes (EBT) 
$34.667 million - ($200 million x 10%) = $14.667 million EBT

Then, we calculate the amount of taxes: 
$14.667 million x 40% = $5.867 million

Net Income = EBT - Taxes 
$14.667 million - $5.867 million = $8.8 million

Next, we calculate the amount of equity the company needs to maintain its optimal capital structure: 
Equity = Total Assets - Debt 
$200 million x 60% = $120 million

So, the company needs $120 million in equity. Since the company has $20 million in capital budget and needs $120 million in equity, it will have $100 million available to pay dividends.

Dividend Payout Ratio = Dividends / Net Income 
Dividend Payout Ratio = $100 million / $8.8 million 
Dividend Payout Ratio = 11.36 = 11.36%

However, we need to convert this ratio to a percentage, so we multiply by 100: 
Dividend Payout Ratio = 11.36 x 100% = 25%

Therefore, the answer is C) 25%.

Your Company Has Decided That Its Capital Budget During the Coming