Chapter 14, Problem 10SP

a.

Summary Introduction

To calculate: Amount of retained earnings required for funding the capital budget.

Introduction:

Residual Dividend Policy: Under the residual dividend policy, the company gives first preference to the current capital investment. The amount remaining after the capital investment is distributed among the shareholders as dividend.

Explanation of Solution

Calculate retained earnings.

Given,

Capital budget is $10,000,000.

Capital structure is 60% equity.

Formula to calculate retained earnings,

$\text{Retained}\text{earnings}\text{needed}=\text{Capital}\text{budget}\times \text{Equity}\text{\%}$

Substitute $10,000,000 for capital budget and 60% for equity %.

$\begin{array}{c}\text{Retained}\text{earnings}\text{needed}=\$10,000,000\times 60\%\\ =\$6,000,000\end{array}$

Conclusion

Retained earnings required to fund the capital budget is $6,000,000

b.

Summary Introduction

To calculate: Company’s dividend per share and payout ratio.

Explanation of Solution

Calculate residual dividend.

Given,

Net income is $8,000,000.

Retained earnings are $6,000,000.

Formula to calculate residual dividend,

$\text{Residual}\text{dividend}=\text{Net}\text{income}-\text{Retained}\text{earnings}$

Substitute $8,000,000 for net income and $6,000,000 for retained earnings.

$\begin{array}{c}\text{Residual}\text{dividend}=\text{\$8,000,000}-\$6,000,000\\ =\$2,000,000\end{array}$

So,residual dividend is $2,000,000.

Calculate dividend per share.

Given,

Residual dividend is $2,000,000.

Shares outstanding are 1,000,000.

Formula to calculate dividend per share,

$\text{Dividend}\text{per}\text{share}=\frac{\text{Residual}\text{dividend}}{\text{Shares}\text{Outstanding}}$

Substitute $2,000,000 for residual dividend and 1,000,000 for shares outstanding.

$\begin{array}{c}\text{Dividend}\text{per}\text{share}=\frac{\text{\$2,000,000}}{\text{1,000,000}}\\ =\$2\end{array}$

So, dividend per share is $2.

Calculate payout ratio.

Given,

Residual dividend is $2,000,000.

Net income is $8,000,000.

Formula to calculate payout ratio,

$\text{Payout}\text{ratio}=\frac{\text{Residual}\text{dividend}}{\text{Net}\text{income}}$

Substitute $2,000,000 for residual dividend and $8,000,000 for net income.

$\begin{array}{c}\text{Payout}\text{ratio}=\frac{\$2,000,000}{\text{\$8,000,000}}\\ =0.25\\ =25\%\end{array}$

So, payout ratio is 25%.

Conclusion

The dividend per share is $2 while the payout ratio is 25%

c.

Summary Introduction

To calculate: Retained earnings at $3 dividend per share for the next year.

Explanation of Solution

Calculate retained earnings.

Given,

Net income is $8,000,000.

Shares outstanding are 1,000,000.

Dividend per share is $3.

Formula to calculate retained earnings available,

$\text{Retaind}\text{earnings}\text{available}=\left[\begin{array}{l}\text{Net}\text{Income}\\ -\text{Dividend}\text{per}\text{share}\left(\text{Outstanding}\text{shares}\right)\end{array}\right]$

Substitute $8,000,000 for net income, 1,000,000 for outstanding shares and $3 for dividend per share.

$\begin{array}{c}\text{Retaind}\text{earnings}\text{available}=\text{\$8,000,000}-\text{\$3}\left(1,000,000\right)\\ =\$5,000,000\end{array}$

Conclusion

The retained earnings available will be of $5,000,000.

d.

Summary Introduction

To explain: Whether it is possible to maintain current capital structure at $3 dividend per share and the capital budget of $10 million without raising new stock.

Answer to Problem 10SP

No, it is not possible.

Explanation of Solution

• It is not possible because at $3 dividend per share the retained earnings available are of only $5,000,000.
• If the company doesn’t want to change its current capital structure, then the equity of $6,000,000 will be required and to arrange this amount of equity, company has to issue additional stock of $1,000,000.

Conclusion

So, to maintain current capital structure, it is required to issue additional stock of $1,000,000.

e.

Summary Introduction

To calculate: Portion of capital budget to be financed for the debt.

Explanation of Solution

Calculate retained earnings.

Given,

Net income $8,000,000

Dividend $3,000,000

Formula to calculate retained earnings available,

$\text{Retained}\text{earnings}\text{available}=\text{Net}\text{income}-\text{Dividends}$

Substitute $8,000,000 for net income and $3,000,000 for dividend.

$\begin{array}{c}\text{Retained}\text{earnings}\text{available}=\text{\$8,000,000}-\$3,000,000\\ =\$5,000,000\end{array}$

So, retained earnings available are $5,000,000.

Calculateportion of capital budget financed with retained earnings.

Given,

Retained earnings are $5,000,000.

Capital budget is $10,000,000.

Formula to calculate portion of capital budget financed with retained earnings,

$\left[\begin{array}{l}\text{Portion of capital budget}\\ \text{financed with retained earnings}\end{array}\right]=\left[\frac{\text{Retained}\text{earnings}\text{available}}{\text{Capital}\text{Budget}}\right]$

Substitute $10,000,000 for capital budget and $5,000,000 for retained earnings.

$\begin{array}{c}\left[\begin{array}{l}\text{Portion of capital budget}\\ \text{financed with retained earnings}\end{array}\right]=\frac{\$5,000,000}{\$10,000,000}\\ =50\%\end{array}$

So, portion of capital budget financed with retained earnings is 50%.

Calculate portion of capital budget financed with debt.

Given,

Amount available for debt is $5,000,000.

Capital budget is $10,000,000.

Formula to calculate portion of capital budget financed with debt,

$\text{Portion of capital budget financed with debt}=\frac{\text{Amount}\text{of}\text{debt}\text{available}}{\text{Capital}\text{budget}}$

Substitute $10,000,000 for capital budget and $5,000,000 for amount available for debt.

$\begin{array}{c}\text{Portion of capital budget financed with debt}=\frac{\$5,000,000}{\$10,000,000}\\ =50\%\end{array}$

Conclusion

So, portion of capital budget financed with debt is 50%.

f.

Summary Introduction

To calculate: The new stock the company would have to issue to meet its objectives.

Explanation of Solution

Calculate equity needed.

Given,

Capital budget is $10,000,000.

Capital structure is 60% equity.

Formula to calculate equity needed,

$\text{Equity}\text{needed}=\text{Capital}\text{budget}\times \text{Equity}\text{\%}$

Substitute $10,000,000 for capital budget and 60% for equity.

$\begin{array}{c}\text{Equity}\text{needed}=\$10,000,000\times 60\%\\ =\$6,000,000\end{array}$

So, equity needed is of $6,000,000.

Calculate retained earnings available.

Given,

Net income is $8,000,000.

Shares outstanding are 1,000,000.

Dividend per share is $3.

Formula to calculate retained earnings available,

$\text{Retaind}\text{earnings}\text{available}=\left[\begin{array}{l}\text{Net}\text{Income}\\ -\text{Dividend}\text{per}\text{share}\left(\text{Outstanding}\text{shares}\right)\end{array}\right]$

Substitute $8,000,000 for net income, 1,000,000 for outstanding shares and $3 for dividend per share.

$\begin{array}{c}\text{Retaind}\text{earnings}\text{available}=\text{\$8,000,000}-\text{\$3}\left(1,000,000\right)\\ =\$5,000,000\end{array}$

So, retained earnings available are $5,000,000.

Calculatenew equity needed.

Given,

Equity needed is $6,000,000.

Retained earnings available are $5,000,000.

Formula to calculate new equity needed,

$\text{New}\text{equity}\text{needed}=\text{Equity}\text{needed}-\text{Retained}\text{earnings}\text{available}$

Substitute $5,000,000 for retained earnings available and $6,000,000 for equity needed.

$\begin{array}{c}\text{New}\text{Equity}\text{needed}=\text{\$6,000,000}-\$5,000,000\\ =\$1,000,000\end{array}$

Conclusion

Amount of new stock that the company would have to issue to meet its objectives is of$1,000,000.

g.

Summary Introduction

To calculate: Capital budget for next year.

Explanation of Solution

Calculate retained earnings available.

Given,

Net income is $8,000,000.

Share outstanding is 1,000,000.

Dividend per share is $3.

Formula to calculate retained earnings available,

$\text{Retaind}\text{earnings}\text{available}=\left[\begin{array}{l}\text{Net}\text{Income}\\ -\text{Dividend}\text{per}\text{share}\left(\text{Outstanding}\text{shares}\right)\end{array}\right]$

Substitute $8,000,000 for net income, 1,000,000 for outstanding shares and $3 for dividend per share.

$\begin{array}{c}\text{Retaind}\text{earnings}\text{available}=\text{\$8,000,000}-\text{\$3}\left(1,000,000\right)\\ =\$5,000,000\end{array}$

So, retained earnings available are $5,000,000.

Calculate capital budget.

Given,

Required equity is $5,000,000.

Equity ratio is 60%.

Formula to calculate capital budget,

$\text{Required}\text{Equity}=\text{Capital}\text{budget}\times \text{Target}\text{equity}\text{ratio}$

Substitute $5,000,000 for required equity and 0.6 for target equity ratio,

$\begin{array}{c}\text{\$5,000,000}=\text{Capital}\text{budget}\times \text{0}\text{.6}\\ \text{Capital}\text{budget}=\frac{\$5,000,000}{0.6}\\ =\$8,333,333.333\end{array}$

Conclusion

Capital budget required is of $8,333,333.333.

h.

Summary Introduction

To explain: Actions to be taken when forecasted retained earnings are lesser than the required earnings.

Answer to Problem 10SP

The firm has to take certain steps to fix this.

Explanation of Solution

• A firm can cut its dividend to meet the requirement.
• Changing the capital structure that is using more debt will work in favor.
• Reducing the capital budget and issuing new common stock will work as a wonder for the firm.

Conclusion

The above explained steps will help the firm in case when the forecasted retained earnings are less than required earnings.