Step 2 using the optimal capital structure

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Unformatted text preview: S) and weighted marginal cost of capital (WMCC) schedule (see Chapter 11). Step 2 Using the optimal capital structure proportions (see Chapter 12), estimate the total amount of equity financing needed to support the expenditures generated in Step 1. Step 3 Because the cost of retained earnings, kr, is less than the cost of new common stock, kn, use retained earnings to meet the equity requirement determined in Step 2. If retained earnings are inadequate to meet this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the surplus amount—the residual—as dividends. According to this approach, as long as the firm’s equity need exceeds the amount of retained earnings, no cash dividend is paid. The argument for this approach is CHAPTER 13 Dividend Policy 563 that it is sound management to be certain that the company has the money it needs to compete effectively. This view of dividends suggests that the required return of investors, ks, is not influenced by the firm’s dividend policy—a premise that in turn implies that dividend policy is irrelevant. FIGURE 13.1 WMCC and IOSs WMCC and IOSs for Overbrook Industries Overbrook Industries, a manufacturer of canoes and other small watercraft, has available from the current period’s operations $1.8 million that can be retained or paid out in dividends. The firm’s optimal capital structure is at a debt ratio of 30%, which represents 30% debt and 70% equity. Figure 13.1 depicts the firm’s weighted marginal cost of capital (WMCC) schedule along with three investment opportunities schedules. For each IOS, the level of total new financing or investment determined by the point of intersection of the IOS and the WMCC has been noted. For IOS1, it is $1.5 million, for IOS2 $2.4 million, and for IOS3 $3.2 million. Although only one IOS will exist in practice, it is useful to look at the possible dividend decisions generated by applying the residual theory in each of the three cases. Table 13.1 summarizes this analysis. Table 13.1 shows that if IOS1 exists, the firm will pay out $750,000 in dividends, because only $1,050,000 of the $1,800,000 of available earnings is needed. A 41.7% payout ratio results. For IOS2, dividends of $120,000 (a payout ratio of 6.7%) result. Should IOS3 exist, the firm would pay no dividends (a 0% payout ratio), because its retained earnings of $1,800,000 would be less than the $2,240,000 of equity needed. In this case, the firm would have to obtain additional new common stock financing to meet the new requirements generated by the intersection of the IOS3 and WMCC. Depending on which IOS exists, the firm’s dividend would in effect be the residual, if any, remaining after all acceptable investments had been financed. Weighted Average Cost of Capital and IRR (%) EXAMPLE WMCC 25 20 15 IOS3 IOS2 10 IOS1 5 0 1 1.5 2 2.4 3 3.2 4 5 Total New Financing or Investment ($000,000) 564 PART 4 Long-Term Financial Decisions TABLE 13.1 Applying the Residual Theory of Div...
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