Suppose that you are analysing the capital requirements for your Corporation for next year. You forecast that the company will need $15 million to fund all of its positive-NPV projects and you job is to determine how to raise the money. The corporation’s net income is $11 million, and it has paid a $2 dividend per share (DPS) for the past several years (1 million shares of common stock are outstanding); its shareholders expect the dividend to remain constant for the next several years. The company’s target capital structure is 30% debt and 70% equity.
Questions:
A. Suppose the firm follows the residual model and makes all distributions as dividends. How much retained earnings will it need to fund its capital budget?
B. If the company follows the residual model with all distributions in the form of dividends, what will be its dividend per share and pay-out ratio for the upcoming year?
C. If the company maintains its current $2 DPS for next year, how much retained earnings will be available for the firm’s capital budget?
D. Can the company maintain its current capital structure, maintain its current dividend per share, and maintain a $15 million capital budget without having to raise new common stock? Why or why not?
E. Suppose management is firmly opposed to cutting the dividend; that is, it wishes to maintain the $2 dividend for the next year. Suppose also that the company is committed to funding all profitable projects and is willing to issue more debt (along with the available retained earnings) to help finance the company’s capital budget. Assume the resulting change in capital structure has a minimal impact on the company’s composite cost of capital, so that the capital budget remains at $15 million. What portion of this year’s capital budget would have to be financed with debt?
F. Suppose once again that management wants to maintain the $2 DPS. In addition, the company wants to maintain its target capital structure (30% debt, 70% equity) and its $15 million capital budget. What is the minimum dollar amount of new common stock the company would have to issue in order to meet all of its objectives?
G. Now consider the case in which management wants to maintain the $2 DPS and its target capital structure but also wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming the company’s projects are divisible, what will be the company’s capital budget for the next year?
H. If a firm follows the residual distribution policy, what actions can it take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?
I. Define the term ‘Dividend Policy’? What are the main elements of the Dividend Policy?
J. What are the different theories on investor preference for dividends? Explain each theory?