Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. In its next capital budgeting cycle, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio?
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A. B. C. D. E.E
EBIT$2,000,000 -
- I500,000 ($5,000,000 debt x 10% coupon)
EBT1,500,000 -
- Taxes600,000 ($1,500,000 EBT x 40% tax rate)
NI900,000 -
Project funding $1,200,000 project funded:
Residual earnings 0.60 equity = $720,000
0.40 debt = $480,000
Payable as dividends: 900,000 - 720,000 = $180,000
Dividend payout ratio = $180,000/$900,000 = 20%.