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RESIDUAL DIVIDEND MODEL Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $ 3 . 0 0 dividend

RESIDUAL DIVIDEND 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 companys target capital structure is 60% equity and 40% 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 (that is, 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?
b) If Buena Terra follows the residual dividend model, what will be the companys dividend per
share and payout ratio for the upcoming year?
c) If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be
available for the firms capital budget?
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?
e) Suppose that Buena Terras management is firmly opposed to cutting the dividend; that is, it
wants to maintain the $3.00 dividend for the next year. Also assume that the company was
committed to funding all profitable projects and was willing to issue more debt (along with the
available retained earnings) to help finance the companys capital budget. Assume that the
resulting change in capital structure has a minimal effect on the companys composite cost of
capital so that the capital budget remains at $10 million. What portion of this years capital
budget would have to be financed with debt?
f) Suppose once again that Buena Terras management wants to maintain the $3.00 DPS.In
addition, the company wants to maintain its target capital structure (60% equity and 40% debt)
and maintain its $10 million capital budget. What is the minimum dollar amount of new
common stock that the company would have to issue to meet each of its objectives?
g) Now consider the case where Buena Terras management wants to maintain the $3.00 DPS and
its target capital structure, but it wants to avoid issuing new common stock. The company is
willing to cut its capital budget to meet its other objectives. Assuming that the companys
projects are divisible, what will be the companys capital budget for the next year?
h) What actions can a firm that follows the residual dividend policy take when its forecasted
retained earnings are less than the retained earnings required to fund its capital budget?

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