In 2007 the Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. 2007 was a normal year, and for the past 10 years, earnings have grown at a constant rate of 10%. However, in 2008, 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 2008 level of earnings growth-the high 2008 earnings level is attributable to an exceptionally profitable new product line introduced that year-and the company will return to its previous 10% growth rate. Keenan's target debt ratio is 40%.
a. Calculate Keenan's total dividends for 2008 if it follows each of the following policies:
(1) Its 2008 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.
(2) It continues the 2007 dividend payout ratio.
(3) It uses a pure residual policy with all distributions in the form of dividends (40% of the $8.4 million investment is financed with debt).
(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 policy.
b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed, but justify your answer.
c. Does a 2008 dividend of $9,000,000 seem reasonable in view of your answers to parts a and b? If not, should the dividend be higher or lower?