Target debt ratio & Target payout ratio in Capital Budget

Question

Assume that a firm has a number of positive NPV projects available but does not want to issue any new stock. The projected net income is $150 MM with a target capital structure of 25% debt and 75% equity. The target payout ratio is 65%. You are asked to determine the maximum capital budget given possible changes in capital structure and/or dividend payout policy. Versus the current policy, how much larger could the capital budget be if: A. The target debt ratio were raised to 75%

B. The target payout ratio were lowered to 20%

C. Both A and B were changed, as indicated

Answer 1

The firm is financed with a combination of debt and equity. Since they do not want to issue any new debt, the only available financing is from this year’s retained earnings (equity) and additional debt issued. We have $150M of Net Income, but are paying out 65% as dividends, so the net increase in equity is $52.5. Since we have $1 of debt financing for every $3 of equity financing, we can also issue an additional $17.5M of debt, making our total capital budget $70M.

Under Scenario A, we still have $52.5M of debt financing. However, we now have $3 of debt financing for every $1 of equity financing, meaning we can issue an additional $157.5M of debt, for a total capital budget of $210M.

Under Scenario B, we are now only paying out 20% of our Net Income as dividends, which means we have $120M of equity financing. Since we have $1 of debt for every $3 of equity, we would have an additional $40M of debt available, for a total budget of $160M

Under both changes from A and B, we would have the same $120M of equity financing available from scenario B. However, we would now have $3 of debt for every $1 of equity, which is an additional $360M of debt financing, for a total budget of $480M.