Clark Farms Inc.has the following data,and it follows the residual dividend model.Currently,it finances with 20% 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?

A) $1,923,900
B) $1,669,500
C) $1,494,600
D) $1,590,000
E) $1,192,500

Question

Clark Farms Inc.has the following data,and it follows the residual dividend model.Currently,it finances with 20% 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?

A) $1,923,900 
B) $1,669,500 
C) $1,494,600 
D) $1,590,000 
E) $1,192,500

Quizplus · Accepted Answer

According to the residual dividend model, dividends are paid using the following formula:

Dividend = Net Income - (1 - Dividend Payout Ratio) x Equity
where Dividend Payout Ratio = 1 - (Debt/Equity)

Currently, the debt-to-equity ratio of Clark Farms Inc. is 20%/80% = 0.25.

Let's assume that Clark Farms Inc. can increase its debt-to-equity ratio to 40%/60% = 0.67. This means that the new equity-to-assets ratio will be 1 - 0.67 = 0.33.

Using the residual dividend model, we can calculate the maximum dividend that can be paid as follows:

Dividend = Net Income - (1 - Dividend Payout Ratio) x Equity
where Net Income = $3,200,000 (given), Equity = Total Assets x Equity-to-Assets Ratio = $20,000,000 x 0.33 = $6,600,000

Also, Dividend Payout Ratio = 1 - (Debt/Equity) = 1 - 0.67 = 0.33

Therefore, Dividend = $3,200,000 - (1 - 0.33) x $6,600,000 = $1,590,000

So, if Clark Farms Inc. increases its debt-to-equity ratio to 40%/60%, it can increase its dividend by $1,590,000 - $1,272,000 = $318,000.

Therefore, the correct answer is D) $1,590,000.