Chapter 14, Problem 11P

a)

Summary Introduction

To determine: Amount of retained earnings needed by company K to fund its capital budget.

Explanation of Solution

Given information:

Capital budget is $15,000,000

Net income is $11 million,

DPS dividend per share is $2,

Outstanding shares 1 million,

Capital structure is 30% debt and 70% equity.

Calculation of retained earnings:

$\begin{array}{c}\text{Retained earnings}=\$15,000,000\times 0.70\\ =\$10,500,000\end{array}$

Therefore, retained earnings needed is amounted to $10,500,000

b)

Summary Introduction

To determine: Dividend per share (DPS) and pay-out ratio.

Explanation of Solution

Based on the residual dividend model, the amount $500,000 ($11,000,000-$10,500,000) is available for dividends.

Calculation of dividend per share:

$\begin{array}{c}\text{DPS}=\frac{\text{Dividends}\text{available}}{\text{Outstanding}\text{shares}}\\ =\frac{\$500,000}{1,000,000}\\ =\$0.50\end{array}$

Therefore, dividend per share is $0.50

Calculation of pay-out ratio:

$\begin{array}{c}\text{Pay-out ratio}=\frac{\text{Dividends}\text{available}}{\text{Net}\text{income}}\\ =\frac{\$500,000}{\$11,000,000}\\ =4.55\%\end{array}$

Therefore, pay-out ratio is 4.55%

c)

Summary Introduction

To determine: Amount of retained earnings needed by company K to fund its capital budget, if it maintains $2 DPS for next year.

Explanation of Solution

Calculation of retained earnings:

$\begin{array}{c}\text{Retained earnings available}=\$11,000,000-\$2\left(1,000,000\right)\\ =\$11,000,000-\$2,000,000\\ =\$9,000,000\end{array}$

Therefore, retained earnings available is amounted to $9,000,000

d)

Summary Introduction

To determine: Whether company maintains its current capital structure with its DPS and maintain $15 million capital budget without raising new common stock.

Explanation of Solution

Person X views that, company does not maintain because, if it maintains $2 DPS, only $9 million of retained earnings is available for capital projects. However, if the firm is to keep up its current capital structure of $10.5 million of equity is needed. This may necessitate the company to issue $1.5 million of common stock.

e)

Summary Introduction

To determine: Portion of current year capital budget could have to be financed by debt.

Explanation of Solution

Retained earnings available is $9,000,000

Calculation of Capital budget financed with Retained earnings:

$\begin{array}{c}\text{Percentage}\text{of}\text{capital budget}=\frac{\text{Retained}\text{earings}\text{available}}{\text{capital}\text{budget}}\\ =\frac{\$9,000,000}{\$15,000,000}\\ =60\%\end{array}$

Therefore, percentage of capital budget financed by retained earnings is 60%

Calculation of Capital budget financed with debt:

$\begin{array}{c}\text{Percentage}\text{of}\text{capital budget}=\frac{\text{Debt}\text{available}}{\text{capital}\text{budget}}\\ =\frac{\$6,000,000}{\$15,000,000}\\ =40\%\end{array}$

Therefore, percentage of capital budget financed by debt is 40%

f)

Summary Introduction

To determine: External (new) equity needed.

Explanation of Solution

$\begin{array}{c}\text{Equity}\text{needed}=\$15,000,000\times 0.70\\ =\$10,500,000\end{array}$

Calculation of retained earnings:

$\begin{array}{c}\text{Retained earnings available}=\$11,000,000-\$2\left(1,000,000\right)\\ =\$11,000,000-\$2,000,000\\ =\$9,000,000\end{array}$

Therefore, retained earnings available is amounted to $9,000,000

Calculation of external equity needed:

$\begin{array}{c}\text{External equity needed}=\$10,500,000-\$9,000,000\\ =\$1,500,000\end{array}$

Therefore, external (new) equity needed is $1,500,000

g)

Summary Introduction

To determine: Company’s capital budget for next year.

Explanation of Solution

Calculation of retained earnings:

$\begin{array}{c}\text{Retained earnings available}=\$11,000,000-\$2\left(1,000,000\right)\\ =\$11,000,000-\$2,000,000\\ =\$9,000,000\end{array}$

Therefore, retained earnings available is amounted to $9,000,000

Retained earnings availability is equals the required equity to find new capital budget.

Calculation of capital budget using required equity:

$\begin{array}{c}\text{Required}\text{equity}=\text{Capital}\text{budget}\left(\text{Target}\text{equity}\text{ratio}\right)\\ \$9,000,000=\text{Capital}\text{budget}\left(0.7\right)\\ \text{Capital}\text{budget}=\$12,857,143\end{array}$

Hence, capital budget is $12,857,143

Therefore, if Company R cuts its capital budget from $15 million to $12.86 million, it will maintain its DPS $2.00, its current capital structure and still follow its residual dividend policy.

h)

Summary Introduction

To determine: Actions taken by company when its forecasted retained earnings are less than retained earnings required.

Explanation of Solution

Company can take any one of the following four actions,

• New issue of common stock,
• Cuts its capital budget,
• Company cuts the dividends,
• Change the capital structure by using more debt funds.

Company should realize that every of these actions is not while not consequences to its cost of capital, stock price or both.