PROBLEM 15-6 SOLUTION
Residual Dividend Model.
Walsh Company is considering three independent projects, each of which requires a $4 million
investment. The estimated internal rate of return (IRR) and cost of capital for these projects are
presented here:
Project
Project H (High Risk)
Project M (Medium Risk)
Project L (Low Risk)
Cost of Capital
16%
12%
9%
IRR
19%
13%
8%
Note that the projects’ costs of capital vary because the projects have different levels of risk. The
company’s optimal capital structure calls for 40% debt and 60% common equity, and it expects to
have net income of $7,500,000. If Walsh establishes its dividends from the residual dividend model,
what will be its payout ratio?
STEP 1: Identify Total Capital Budget
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Decision Rule for IRR: Accept project if IRR is greater than Cost of Capital
o Only projects H and M can be accepted since there IRRs are greater than the cost of
capital (i.e., 2 of 3 project proposals are accepted)
o Therefore:
Total Capital Budget = $4,000,000 x 2
= $8,000,000
Total capital budget for the year is $8,000,000
STEP 2: Calculate Dividends Using Residual Dividend Model
-
Formula for Residual Dividend Model:
-
Therefore:
Dividends = 7,500,000 - ( 60% x 8,000,000)
= 7,500,000 - 4,800,000
= 2,700,000
Walsh can distribute $2,700,000 of its net income as dividends
STEP 3: Calculate the Dividend Payout Ratio
-
Formula for Dividend Payout Ratio
-
Therefore:
Dividend Payout Ratio = 2,700,000 / 7,500,000
= 0.36 or 36 %
Walsh's Dividend Payout Ratio is 36%