Flavortech Inc.expects EBIT of $2,000,000 for the coming year.The firm's capital structure consists of 40 percent debt and 60 percent equity,and its marginal tax rate is 40 percent.The cost of equity is 14 percent,and the company pays a 10 percent rate on its $5,000,000 of long-term debt.One million shares of common stock are outstanding.In its next capital budgeting cycle,the firm expects to fund one large positive NPV project costing $1,200,000,and it will fund this project in accordance with its target capital structure.If the firm follows a residual dividend policy and has no other projects,what is its expected dividend payout ratio?
A) 100%
B) 60%
C) 40%
D) 20%
E) 0%

Question

Quizplus · Accepted Answer

The firm will fund the project with 40% debt and 60% equity. The equity portion is $720,000 (60% of $1,200,000). The residual income available for dividends is EBIT after interest and taxes minus the equity portion of the project. The dividend payout ratio is the residual income divided by net income.