Sirmans Company Dividend Policies and Cost of Equity Analysis: A Comprehensive Guide
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In 2015, the Sirmans Company paid dividends totaling $3,600,000 on net income of $10.8 million. The year 2015 was a normal one for the company, and for the past 10 years, earnings have grown at a co
In 2015, the Sirmans Company paid dividends totaling $3,600,000 on net income of $10.8 million. The year 2015 was a normal one for the company, and for the past 10 years, earnings have grown at a constant rate of 10 percent. In 2016, earnings are expected to jump to $14.4 48 million, and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that Sirmans will not be able to maintain the 2016 level of earnings growth—the high 2016 earnings level is attributable to an exceptionally profitable new product line introduced that year—and the company will return to its previous 10 percent growth rate. Sirmans’s target debt/assets ratio is 40 percent. a. Calculate Sirmans’s total dividends for 2016 if it follows each of the following policies: (1) Its 2016 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. (2) It continues the 2015 dividend payout ratio. (3) It uses a pure residual dividend policy (40 percent of the $8.4 million investment is financed with debt). (4) It employs a regular-dividend-plus-extras policy. The regular dividend is based on the long run growth rate and the extra dividend is 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. Assume that investors expect Sirmans to pay total dividends of $9 million in 2016 and to have the dividend grow at 10 percent after 2016. The total market value of the stock is $180 million. What is the company’s cost of equity?
Assignment Preview:
a. (1) Long-run growth rate in earnings: The long-run growth rate for earnings is 10%. If we assume that the company wants to maintain the same payout ratio as in 2015, we can calculate the 2016 dividends as follows: $10.8 million (2015 net income) * 0.3333 (2015 dividend payout ratio) = $3,600,000 (2015 dividends). To maintain the same payout ratio in 2016, we can multiply the 2016 net income by 0.3333 to find the dividends: $14.448 million (2016 net income) * 0.3333 = $4,801,600 (2016 dividends).
(2) 2015 dividend payout ratio: If the company wants to maintain the same dividend payout ratio as in 2015, we can calculate the 2016 dividends as follows: $14.448 million (2016 net income) * 0.3333 (2015 dividend payout ratio) = $4,801,600 (2016 dividends)
(3) Pure residual policy: The company’s target debt/assets ratio is 40%. The company expects to have $8.4 million in investment opportunities in 2016. If the company wants to finance 40% of these investments with debt, it will need to finance $3,360,000 (40% of $8.4 million) with debt. The company can use the remaining $5,040,000 ($8.4 million – $3,360,000) to pay dividends.
(4) Regular-dividend-plus-extras policy: The regular dividend is based on the long-run growth rate, so it will be $4,801,600 as calculated above. To calculate the extra dividend, we can use the pure residual policy. The company expects to have $8.4 million in investment opportunities and it wants to finance 40% of these investments with debt. So, it will have $5,040,000 to pay dividends. The extra dividend for 2016 will be: $5,040,000 – $4,801,600 = $238,400
b. From the above calculations, it appears that the regular-dividend-plus-extras policy will provide the highest dividends to shareholders in 2016, $4,801,600 + $238,400 = $5,040,000. This policy also allows the company to invest in profitable opportunities while still paying dividends at a sustainable rate. Therefore, I would recommend this policy.
c. To calculate the company’s cost of equity, we can use the Gordon Growth Model, which states that:
Cost of equity = Dividend per share / Price per share + Dividend growth rate
where Dividend per share is the expected total dividends for 2016 ($9 million) / Number of shares outstanding (unknown), Price per share is the total market value of the stock ($180 million) / Number of shares outstanding (unknown) and the Dividend growth rate is the expected growth rate in dividends after 2016 (10%).
Since we don’t know the number of shares outstanding, we can’t find the cost of equity with the information provided.
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