Residual dividend policy

CFA Level II
#1

Q from eoc cfa book

Wilson’s board has also approved capital spending of US$15 million to be entirely funded out of this year’s earnings.

Book value of equity US$750 million (US$30 a share) Shares outstanding 25 million 12-month trading range US$25–US$35 Current share price US$35 After-tax cost of borrowing 7% Estimated full year earnings US$25 million Last year’s dividends US$9 million Target capital structure (market value) 35% debt, 65% equity

Assume that Wilson Chemical funds its capital spending out of its estimated full year earnings. If Wilson uses a residual dividend policy, determine Wilson’s implied dividend payout ratio.

  1. 36%.
  2. 40%.
  3. 60%

the correct answer is B which I ended up getting correct but by guessing. My calculations were as follows. Capital spending is $15 million dollars and the capital structure is 35% debt and 65% equity. so I did .35*$15 million= $5.25 million. the remaining is equity which is $19.75 million dollars. $9 million in dividends were paid so thats 9/19.75= 45%. why is this not correct? cfa uses this method instead which is $25 million- $15 million= 10 million in equity/25= 40%. this doesnt make sense to me. I used my method for another question which is below and got it right.

“The Apex Corp. has a target capital structure of 40% debt and 60% equity. Its capital budget for next year is estimated to be US$40 million. Estimated net income is US$30 million. If Apex follows a residual dividend policy, its dividend is expected to be”- Answer is US$6 million which I got by 40%*40 million = 16 million debt. net income - debt that has to be paid off first= $24 million dollars left over in equity. the remainder is $30 in net income - $24 million in equity = $6 million in dividends.

can someone please explain to me whats the difference between these 2 questions are and why my method doesn’t work for the 1st question posted?

#2

Hey there,

So the question states that they will be funding their project via this years " EARNINGS". now if they had specifically mentioned(eg - 40% would be through debt and the rest through equity), thats when you’d take 60% of the project value, negate it from your net income and get the dividends. In this question, am using my earnings to fund the project and so this is how its gonna go:

$25M - $15M = $10M = reisdual dividend.

$10M/$25 = 40% payout.

Watch out for the wording in the questions.

#3

Ah I see what you are saying. because they are funding through earnings no additional/separate debt to be taken out hence my original method doesn’t work?

#4

Yeah.