Stargell Industries follows a strict residual dividend policy.The company has a capital budget of $3,000,000.It has a target capital structure which consists of 30 percent debt and 70 percent equity.The company forecasts that its net income will be $3,500,000.What will be the company's payout ratio this year?
A) 25%
B) 30%
C) 35%
D) 40%
E) 45%

Question

Quizplus · Accepted Answer

To determine the company's payout ratio, we first need to calculate the amount of money available for dividends.

Residual dividend policy means that the company will first finance all capital budget projects before paying any dividends. Therefore, the amount available for dividends will be the net income minus the amount needed for the capital budget:

Amount available for dividends = Net income - Capital budget
Amount available for dividends = $3,500,000 - $3,000,000
Amount available for dividends = $500,000

Next, we need to calculate the amount of equity and debt needed to maintain the target capital structure.

Debt percentage = 30%
Equity percentage = 70%
Total capital = $3,000,000

Debt needed = 30% x $3,000,000 = $900,000
Equity needed = 70% x $3,000,000 = $2,100,000

Lastly, we can calculate the payout ratio based on the amount available for dividends and the net income:

Payout ratio = Dividends / Net income
Payout ratio = $500,000 / $3,500,000
Payout ratio = 0.1429 or 14.29%

However, we need to consider the company's strict residual dividend policy. If the payout ratio calculated above is lower than the minimum percentage of net income that the company wants to pay as dividends, then the company will pay the minimum percentage instead.

In this case, since the company follows a strict residual dividend policy, we can assume that the minimum percentage is 40% of net income.

Minimum dividends = 40% x $3,500,000 = $1,400,000

Since the amount available for dividends based on the capital budget and target capital structure is lower than the minimum dividends, the company will pay the minimum. Therefore, the payout ratio for the year will be:

Payout ratio = Dividends / Net income
Payout ratio = $1,400,000 / $3,500,000
Payout ratio = 0.4 or 40%

The best choice is D, 40%.

Stargell Industries Follows a Strict Residual Dividend Policy