As CEO of the Denim Company, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks about the company's dividend policy. In fact the stockholder has asked you to estimate the amount of dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you do know the following:

1)The company follows a residual dividend policy.

2)The total capital budget next year is likely to be one of three amounts, depending on the capital budgeting studies that are currently under way. The capital expenditure amounts are $3 Million, $4 Million and $5 Million.

3)The forecasted level of potential retained earnings next year is $3 Million.

4)The target or optimal capital structure is a debt ratio of 25%.

You have decided to respond the stockholder by sending the best information available to you.

(a)Describe a residual dividend policy and explain to your stockholder as to how this policy will benefit him.

(b)Compute the amount of dividend (or the amount of new common stock needed) and the dividend payout ratio for each of the capital expenditure amounts.