A firms optimal capital structure is the mix of debt and equity that maximizes the stock price. As the firm increases financial leverage increased financial risk is borne by the shareholders. When considering the operating leverage and value of the firm, one must consider Modigliani and Millers theory with and without taxes. Since debt adds value to the firm due to the deductibility of interest payments one must be concerned with the benefits of debt and the costs associated with bankruptcy.

The optimal distribution policy strikes a balance between current dividends and future growth to maximize the firms stock price. Three theories to consider when discussing the optimal distribution strategy are the Dividend Irrelevance Theory, Dividend Preference Theory, and the Tax Effect Theory. Investors will be attracted to companies that match their distribution preferences. The dividend irrelevance theory holds that dividend policy has no effect on either the price of a firms stock or its cost of capital. The principal proponents of this view are Merton Miller and Franco Modigliani (MM). They prove their position in a theoretical sense, but only under strict assumptions, some of which are clearly not true in the real world.

This case project will allow the students to distinguish between business risk and financial risk and explain the effects that debt financing has on the firms expected return and risk. The exercise will enlighten the students on why some investors like the firm to pay more dividends while other investors prefer reinvestment and the resulting capital gains.

Assume that Abiproffy has a $112.5 million capital budget planned for the coming year. You have determined its present capital structure (80% equity and 20% debt) is optimal, and its net income is forecasted at $140 million. Use the residual distribution model approach to determine Abiproffys total dollar distribution. Assume for now that the distribution is in the form of a dividend. Abiproffy has 100 million shares. Answer the following questions.

1. What is the forecasted dividend payout ratio?
2. What is the forecasted dividend per share?
3. What would happen to the payout ratio and DPS if net income were forecasted to decrease to $90 million?
4. To increase to $160 million?
5. In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?