Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3 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% equity and 40% debt, it has 1 million shares of common equity outstanding, and its net income is $8 million. The company forecasts it would 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 model and makes all distributions as dividends, how much retained earnings will it need to fund its capital budget?
b. If Buena Terra follows the residual model with all distributions in the form of dividends, what will be the company’s dividend per share and payout ratio for the upcoming year?
c. If Buena Terra maintains its current $3 DPS for next year, how much retained earnings will be available for the firm’s capital budget?
d. Can the company maintain its current capital structure, maintain the $3 DPS, and maintain a $10 million capital budget without having to raise new common stock?
e. Suppose Buena Terra’s management is firmly opposed to cutting the dividend; that is, it wishes to maintain the $3 dividend for the next year. Suppose also 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 company’s capital budget. Assume 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 portion of this year’s capital budget would have to be financed with debt?
f. Suppose once again that Buena Terra’s management wants to maintain the $3 DPS. In addition, the company wants to maintain its target capital structure (60% equity, 40% debt) and its $10 million capital budget. What is the minimum dollar amount of new common stock the company would have to issue in order to meet all of its objectives?
g. Now consider the case in which Buena Terra’s management wants to maintain the $3 DPS and its target capital structure but also wants to avoid issuing new common stock. The company is willing to cut its capital budget in order to meet its other objectives. Assuming the company’s projects are divisible, what will be the company’s capital budget for the next year?
h. If a firm follows the residual distribution policy, what actions can it take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?