In 2004 the Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. 2004 was a normal year, and for the past 10 years, earnings have grown at a constant rate of 10 percent. However, in 2005, earnings are expected to jump to $14.4 million, and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that Keenan will not be able to maintain the 2005 level of earnings growth—the high 2005 earnings level is attributable to an exceptionally profitable new product line introduced that year—and the company will return to its previous 10 percent growth rate. Keenan’s target debt ratio is 40 percent.

a. Calculate Keenan’s total dividends for 2005 if it follows each of the following policies:

(1) Its 2005 dividend payment is set to force dividends to grow at the long run growth rate in earnings.

(2) It continues the 2004 dividend payout ratio.

(3) It uses a pure residual policy with all distributions in the form of dividends (40 percent of the $8.4 million investment is financed with debt).

(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.

b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed, but justify your answer.