Question

A firm takes a loan of $687 at market rate to invest $2,180 for its best investment opportunities. The investment will generate an average return of 26%. Market rate of return is 12%. How much can the firm pay dividend in the next period under two-period perfect certainty model?

Answer 1

The firm can pay $485.36 in dividends in the next period after covering the interest on its loan by using the surplus generated from its investment which yields a return greater than the market rate.

Step-by-step explanation:

The two-period perfect certainty model suggests that a firm can only pay dividends from earnings that exceed its investment needs when those investments yield a return greater than the market rate of interest. The firm has borrowed $687 at a market rate of 12% and invested $2,180 in a project that returns 26% on average. Given that the investment's return exceeds the market rate, the firm can use the surplus earnings to pay dividends.

The calculation for the firm's investment return would be 26% of $2,180, which equates to an income of $567.80. However, the firm also must pay interest on its loan, which amounts to 12% of $687, or $82.44. Thus, the net income available for dividends would be $567.80 - $82.44 = $485.36. Therefore, the firm can pay out $485.36 in dividends in the next period.