520 CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases
cost assumes that all new equity comes from retained earnings. If the company must
issue new stock, its cost of capital will be higher. T&W has $60 million in net income
and a target capital structure of 60 percent equity and 40 percent debt. Provided that
it does not pay any cash dividends, T&W could make net investments (investments in
addition to asset replacements from depreciation) of $100 million, consisting of
$60 million from retained earnings plus $40 million of new debt supported by the re-
tained earnings, at a 10 percent marginal cost of capital. If the capital budget exceeded
$100 million, the required equity component would exceed net income, which is of
course the maximum amount of retained earnings. In this case, T&W would have to
issue new common stock, thereby pushing its cost of capital above 10 percent.
At the beginning of its planning period, T&W’s financial staff considers all pro-
posed projects for the upcoming period. Independent projects are accepted if their
estimated returns exceed the risk-adjusted cost of capital. In choosing among mutually
exclusive projects, T&W chooses the project with the highest positive NPV. The
capital budget represents the amount of capital that is required to finance all ac-
cepted projects. If T&W follows a strict residual dividend policy, we can see from
Table 14-2 that there may be changes in the dividend payout ratio.
If T&W forecasts poor investment opportunities, its estimated capital budget
will be only $40 million. To maintain the target capital structure, 40 percent of this
capital ($16 million) must be raised as debt, and 60 percent ($24 million) must be
equity. If it followed a strict residual policy, T&W would retain $24 million of its
$60 million earnings to help finance new investments, then pay out the remaining
$36 million as dividends. Under this scenario, the company’s dividend payout ratio
would be $36 million/$60 million 0.6 60%.
By contrast, if the company’s investment opportunities were average, its optimal
capital budget would rise to $70 million. Here it would require $42 million of re-
tained earnings, so dividends would be $60$42$18 million, for a payout of
$18/$6030%. Finally, if investment opportunities are good, the capital budget
would be $150 million, which would require 0.6($150) $90 million of equity. T&W
TABLE 14-1 Dividend Payouts (December 2001)
Dividend Dividend
Company Industry Payout Yield
I. Companies That Pay High Dividends
WD-40 Company (WDFC) Household products 109% 4.8%
Empire District Electric (EDE) Electric utility 166 6.4
Rayonier Inc. (RYN) Forest products 62 3.2
R. J. Reynolds Tobacco (RJR) Tobacco products 78 6.1
Union Planters Corp. (UPC) Regional banks 64 4.6
Ingles Markets Inc. (IMKTA) Retail (grocery) 83 5.5
II. Companies That Pay Little or No Dividends
Tiffany and Company (TIF) Specialty retail 13% 0.6%
Harley-Davidson Inc. (HDI) Recreational products 28 0.2
Aaron Rents Inc. (RNT) Rental and leasing 5 0.3
Delta Air Lines Inc. (DAL) Airline 1 0.4
Papa John’s Intl. Inc. (PZZA) Restaurants 0 0.0
Microsoft Corp. (MSFT) Software and programming 0 0.0
Source:www.marketguide.com, December 2001.
516 Distributions to Shareholders: Dividends and Repurchases
