Question

The residual distribution policy approach to dividend policy is based on the theory that a firm's optimal dividend distribution policy is a function of the firm's target capital structure, the investment opportunities available to the firm, and the availability and cost of external capital. The firm makes distributions based on the residual earnings. Consider the case of Purple Hedgehog Forestry Corporation: Purple Hedgehog Forestry Corporation has generated earnings of $240,000,000 Its target capital structure consists of 60% equity and 40% debt. It plans to spend $83,000,000 on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure. The company makes distributions in the form of dividends. What will Purple Hedgehog Forestry's dividend payout ratio be if it follows a residual distribution policy? O 63.40% O 47.55% O 79.25% O 71.33%

Answer 1

If Purple Hedgehog Forestry Corporation follows a residual distribution policy, its dividend payout ratio would be 63.40%.

Here’s how we can calculate this:

First, we need to determine how much of the $83,000,000 in capital projects will be financed with equity. Since the company’s target capital structure consists of 60% equity and 40% debt, 60% of the $83,000,000 will be financed with equity. This means that the company will need to retain $49,800,000 (0.6 * $83,000,000) of its earnings to finance its capital projects.

Since the company has generated earnings of $240,000,000 and needs to retain $49,800,000 to finance its capital projects, it will have $190,200,000 ($240,000,000 - $49,800,000) left over as residual earnings that can be distributed as dividends.

The dividend payout ratio is calculated by dividing the dividends paid by the company’s earnings. In this case, the dividend payout ratio would be $190,200,000 / $240,000,000 = 0.79375 or 79.375%.

Therefore, if Purple Hedgehog Forestry Corporation follows a residual distribution policy and makes distributions in the form of dividends, its dividend payout ratio would be 79.375%.

Step-by-step explanation: