Ch 18-11 Build a Model Solution							3/6/2001
Chapter 18. Solution to Ch 18-11 Build a Model
Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3.00
dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain
constant for the next several years. The company's target capital structure is 60 percent equity and 40
percent debt. It has 1,000,000 shares of common equity outstanding, and its net income is $8 million.
The company forecasts that it will require $10 million to fund all of its profitable (i.e., positive NPV)
projects for the upcoming year.
a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to
fund its capital budget?
Input Data
Dividend per share		$3.00
Target equity ratio		60%
Target debt ratio		40%
Shares outstanding		1,000,000
Net Income		$8,000,000
Total capital budget		$10,000,000
Required retained earnings =			Total capital budget x		Target equity ratio
Required retained earnings =			$10,000,000	x	60%
Required retained earnings =			$6,000,000
b. If Buena Terra follows the residual dividend model, what will the company's dividend per share
and payout ratio be for the upcoming year?
Dividend per share =		(Net Income	-	Required RE)	/	Shares outstanding
Dividend per share =		$8,000,000	-	$6,000,000	/	1,000,000
Dividend per share =		$2.00	So, following the residual policy would require a dividend cut.
Dividend payout ratio =			Dividend paid	/	Net Income
Dividend payout ratio =			$2,000,000	/	$8,000,000
Dividend payout ratio =			25%
c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings would be
available to support the capital budget?
Desired DPS =		$3.00
Retained earnings for cap. budget =			Net Income	-	DPS	x	# of shares
Retained earnings for cap. budget =			$8,000,000	-	$3.00	x	1,000,000
Retained earnings for cap. budget =			$5,000,000
d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain a
$10 million capital budget without having to raise new common stock?
	Use IF function: Are the retained earnings for the capital budget greater than or equal to the required retained earnings. NO	We see in that the required retained earnings to maintain the capital structure is
	$6 million, while the retained earnings left for the capital budget if the $3 dividend is
	maintained is only $5 million. This means the firm would have to issue new common stock.
e. Suppose that Buena Terra's board is firmly opposed to cutting the dividend, that is, insists on
maintaining the $3.00 dividend. Also, assume that the company is committed to
funding all profitable projects and is willing to issue more debt (along with the available retained
earnings) to help finance the capital budget. Assume that the resulting change in capital
structure has a minimal impact on the company's composite cost of capital, so that the capital budget
remains at $10 million. What % of this year's capital budget would have to be financed with debt?
DPS		$3.00
Total capital budget		$10,000,000
Dividends paid =		DPS	x	# of shares
Dividends paid =		$3.00	x	1,000,000
Dividends paid =		$3,000,000
RE Available =		Net Income	-	Dividends paid
RE Available =		$8,000,000	-	$3,000,000
RE Available =		$5,000,000
Portion of cap. budget from equity =			RE to be used	/	Total capital budget
Portion of cap. budget from equity =			$5,000,000	/	$10,000,000
Portion of cap. budget from equity =			50%
Portion of cap. budget from debt =			100%	-	Portion of cap. budget from equity
			100%	-	50%
Portion of cap. budget from debt =			50%
f. Suppose once again that Buena Terra's management wants to maintain the $3.00 DPS. It also
wants to maintain its target capital structure (60 percent equity, 40 percent debt) and to
finance a $10 million capital budget. What is the minimum dollar amount of new common stock that
must be issued to meet these objectives?
From part A, we see the required retained earnings is $6 million, but we see in part E that there would
only be $ 5million available in retained earnings. Therefore, the company must issue $1 million of stock.
g. Now suppose Buena Terra's management wants to maintain the $3.00 DPS and its target
capital structure, but it does not want to issue new common stock. Management is willing to cut the
capital budget to meet these objectives. Assuming the projects are divisible, what will the company's
capital budget be for the next year?
Total capital budget =		Available RE	/	Target Equity ratio
	=	$5,000,000	/	60%
Total capital budget =		$8,333,333