Response to the following questions:
1. The Welch Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented below:
Project H (high risky): Cost of capital = 16%; IRR = 20%
Project M (medium risk): Cost of capital = 12%; IRR = 10%
Project I. (low risk): Cost of capital = 8%; IRR = 9%
Note that the projects' cost of capital varies because the projects have different levels of risk. The company's optimal capital structure calls for 50 percent debt and 50 percent common equity. Welch expects to have net income of $7,287,500. If Welch bases its dividends on the residual model (all distributions are in the form of dividends), what will its payout ratio be?
2. In 2006 the Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. 2006 was a normal year, and for the past 10 years, earnings have grown at a constant rate of 10 percent. However, in 2007, earnings are expected to jump to $14.4 million, and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that Keenan will not be able to maintain the 2007 level of earnings growth-the high 2007 earnings level is attributable to an exceptionally profitable new product line introduced that year-and the company will return to its previous 10 percent growth rate. Keenan's target debt ratio is 40 percent.
a. Calculate Keenan's total dividends for 2007 if it follows each of the following policies:
(1) Its 2007 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
(2) It continues the 2006 dividend payout ratio.
(3) It uses a pure residual policy with all distributions in the form of dividends (40 percent of the $8.4 million investment is financed with debt).
(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.
b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed, but justify your answer.
c. Does a 2007 dividend of $9,000,000 seem reasonable in view of your answers to parts a and b? If not, should the dividend be higher or lower?