Rohter Galeano Inc. is considering how to set its dividend policy. It has a capital budget of $3,000,000. The company wants to maintain a target capital structure that is 15% debt and 85% equity. The company forecasts that its net income this year will be $3,500,000.
If the company follows a residual dividend policy, what will be its total dividend payment?
Residual Dividend Policy:
Under the residual dividend policy, the dividends are distributed to the shareholders only after the retained earnings are kept aside for the purpose of new investment opportunities. The amount of earnings required to be retained will be equal to the product of the estimated capital budget and the proportion of equity financing in the capital structure.
Answer and Explanation:
Correct answer: Option c) $950,000.
Rohter Galeano Inc has shared the following data:
- Capital budget = $3,000,000
- Forecasted net income = $3,500,000
- Debt financing rate = 15%
- Equity financing rate = 85%
The net income will be first used to finance the investment
- Retained earnings to be used for capital budget = Capital budget * Equity financing rate
- Retained earnings to be used for capital budget = $3,000,000 * 85%
- Retained earnings to be used for capital budget = $2,550,000
- Dividend payout = (Net income - Retained earnings)
- Dividend payout = ($3,500,000 - $2,550,000)
- Dividend payout = $950,000
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from Finance 101: Principles of FinanceChapter 16 / Lesson 1