Alternative dividend policies
In 2015 the Keenan Company paid dividends totaling $2,400,000 on net income of $14 million. Note that 2015 was a normal year and for the past 10 years, earnings have grown at a constant rate of 6%. However, in 2016, earnings are expected to jump to $21 million and the firm expects to have profitable investment opportunities of $10.5 million. It is predicted that Keenan will not be able to maintain the 2016 level of earnings growth because the high 2016 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2016, the company will return to its previous 6% growth rate. Keenan's target capital structure is 40% debt and 60% equity.
a) Calculate Keenan's total dividends for 2016 assuming that it follows each of the following policies: (Write out your answers completely. For example, 25 million should be entered as 25,000,000.)
1) Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
2) It continues the 2015 dividend payout ratio.
3) It uses a pure residual dividend policy (40% of the $10.5 million investment is financed with debt and 60% with common equity).
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 dividend policy.
Regular-dividend $
Extra dividend $
b.) Which of the preceding policies would you recommend?
Policy 1, 2, 3, or 4
c.) Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2016 and to have the dividend grow at 6% after 2016. The stock's total market value is $240 million. What is the company's cost of equity? Round your answer to two decimal places. %
d.) What is Keenan's long-run average return on equity? [Hint: g = Retention rate x ROE = (1.0 - Payout rate)(ROE).] Do not round intermediate calculations. Round your answer to two decimal places. %
e.) Does a 2016 dividend of $9,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower?