In 2017, Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. Note that 2017 was a normal year and that for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2018, 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 2018 level of earnings growth because the high 2018 earnings level is attributable to an exceptionally profitable new product line introduced that year. After 2018, the company will return to its previous 10% growth rate. Keenan’s target capital structure is 40% debt and 60% equity.
a. Calculate Keenan’s total dividends for 2018 assuming that it follows each of the following policies:
1. Its 2018 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
2. It continues the 2017 dividend payout ratio.
3. It uses a pure residual dividend policy (40% of the $8.4 million investment is financed with debt and 60% with common equity).
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 dividend policy.
b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed but justify your answer.
c. Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2018 and to have the dividend grow at 10% after 2018. The stock’s total market value is $180 million. What is the company’s cost of equity?
d. What is Keenan’s long-run average return on equity? [Hint: g 5 Retention rate 3 ROE 5 (1.0 2 Payout rate)(ROE)]
e. Does a 2018 dividend of $9,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower? Explain your answer.