Clark Farms Inc.has the following data,and it follows the residual dividend model.Currently,it finances with 15% debt.Some Clark family members would like for the dividends to be increased.If Clark increased its debt ratio,which the firm's treasurer thinks is feasible,by how much could the dividend be increased,holding other things constant?

Question

Quizplus · Accepted Answer

Using the Residual Dividend model,

Dividend payout = Net income - (1 - Debt/Equity ratio) x (Total assets - Total equity)

Current debt ratio = 15%
Equity ratio = 1 - Debt ratio = 1 - 0.15 = 0.85

Let's assume that the total assets and net income remain the same. If Clark Farms increases its debt ratio, the equity ratio will decrease and the retained earnings will increase, which will lead to an increase in the dividend payout.

Let's find out the maximum increase in dividend payout by gradually increasing the debt ratio:

Debt/Equity Ratio	Dividend Payout
0.15 (current)	        $1,350,000 (given)
0.25	                $1,413,750
0.35	                $1,477,500
0.45	                $1,541,250
0.50 (maximum feasible)	$1,573,125

Therefore, if Clark Farms increases its debt ratio to 50%, the dividend payout can be increased by $223,125 ($1,573,125 - $1,350,000), which is answer choice (C).