Petersen Co. has a capital budget of $1,200,000. The company wants to maintain a target capital structure, which is 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual dividend policy, what will be its payout ratio?
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The amount of new investment, which must be financed with equity, is: $1,200,000 x 40% = $480,000. Since the firm has $600,000 of net income only $120,000 will be left for dividends. This means the payout ratio is $120,000/$600,000 = 20%.