Grant Grocers is considering the following investment projects:
Project Size of Project IRR of Project
V 1.0 million12.0%
W 1.2 million11.5%
X 1.2 million11.0%
Y 1.2 million10.5%
Z 1.0 million10.0%
The company has a target capital structure, which is 50 percent debt and 50 percent equity. The after- tax cost of debt is 8 percent. The cost of retained earnings is estimated to be 13.5 percent. The cost of equity is estimated to be 14.5 percent if the company issues new common stock. The company's net income is $2.5 million. If the company follows a residual dividend policy, what will be its payout ratio?
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A. B. C. D. E.C
The company's WACC (provided no new equity is issued) is 8%(0.5) + 13.5%(0.5) = 10.75%. Comparing the WACC with the project IRRs reveals that the company will undertake projects V, W, and X. Total financing costs for these projects is $3,400,000. Of this amount, 0.5($3,400,000) = $1,700,000 will be financed from retained earnings. Thus, $2,500,000 - $1,700,000 = $800,000 will be available for dividends. The payout ratio is then $800,000/$2,500,000 = 32%.