Finance residual dividend policy approach?

Question

Manufacturing Limited has a target debt/equity ratio of 2/3. It has internally generated after tax cash flows of $50,000,000. Which can be paid out in whole or in part as dividend. It has a corporate tax rate of 40% and cost of capital of 14%. It is considering the following projects.

Project A requires investment of $12,000,000. It will provide before tax cash flow of $5,000,000 one year from today. After that cash flow will decline at the rate of 5% per year forever. Its required rate of return is 15%.

Project B requires investment of $40,000,000. It will provide before tax cash flow of $9,000,000 per year in perpetuity. Its required rate of return is 12%.

Project C requires investment of $38,000,000. It will provide before tax cash flow of $6,000,000 one year from today. After that cash flows will rise at the rate of 4% per year forever. Its required rate of return is 14%.

Project D requires $10,000,000 investment and has an NPV of $2,000,000.

Using the residual dividend policy approach determine which of these four projects UTSC should invest in and what should be the dividend payout.

Answer 1

NPV of Project A = [5*0.6/(0.15-(-0.05))] - 12 = [3/0.2] - 12 = $3M

NPV of Project B = [9*0.6/0.14] - 40 = -$1.43M ==> hurdle rate here is cost of capital (14%)

NPV of Project C = [6*0.6/(0.14-0.04)] - 38 = -$2M

NPV of Project D = $2M

From the 4 scenarios above, looks like Project A has the highest NPV and hence UTSC should invest in Project A.

Given the D/E ratio of 2/3 and the total investment need for $12M, 60% of the investment will come in the form of equity ==> 0.6*12 = $7.2M

Therefore, the after tax cash flow available for the dividend payout = 50 - 7.2 = $42.8M