Help with constant debt-equity ratio in Finance?

Question

Biscuit Motors had earnings of $8 million last year. It made $5 million on investment in projects with positive net present values. Smith owns 20% of the firm’s common stock. Assume that Smith desires no change in proportional ownership of Biscuit Motors and the firm wishes to maintain a constant debt-equity ratio.

What will be Smith’s action in response to

a. Biscuit Motors’s paying out dividends of $5 million?

b. Biscuit Motors’s paying out dividends of $1 million?

c. Biscuit Motors’s paying out dividends of $3 million?

Answer 1

I will be very interested in how other people answer this question. The problem tells of money coming in and the ownership that Smith has in Biscuit Motor's, which is 20%.

Smith wants to maintain 20%. and a constant debt-to-equity ratio.

a.Biscuit Motors’s paying out dividends of $5 million?

From what I can tell Smith will receive $1 million dollars as a dividend from their 20% ownership claim in the company (20% of $5 million).

[I am assuming here these dividends are dispersed in cash. In some cases dividends are paid in stock which would change the capital structure of the company forcing Smith to buy more shares or sell of some of the new ones.]

This is money that has come into the company through revenue, which doesn't change the amount of debt and from what we can tell there are no plans to issue more securities so the equity will not change either.

My guess in each of these is that Smith will gladly accept the dividends that are proportionate to their 20% ownership in the company. Accepting the dividends does not change any of the current ratios or ownership proportions.

Answer 2

Biscuit Motors’s paying out dividends of $3 million.

Note that the key is "maintain a constant debt-equity ratio". The dividends will never influence Smith ownership. To do so, he will have to sell share (or not participate in an increase of stocks).