Question

Banerjee Inc. wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted net income is $825,000, and its board of directors has decreed that no new stock can be issued during the coming year. If the firm follows the residual dividend model, what is the maximum capital budget that is consistent with maintaining the target capital structure?
a. $1,143,214
b. $954,643
c. $1,178,571
d. $1,296,429
e. $1,437,857

Answer 1

The capital budget will be supported with 30% debt and 70% equity. Since the company's income will be $825,000 this is the maximum equity that can be put towards the capital budget and therefor is matched in the ratio 70:30 by borrowings. If $825000 is 70%, divide that (825,000/.70) you’ll get the total maximum budget of $1,178,571 which is letter c. To get the 30%, just deduct the $825,000 to $1,178,571, you’ll get $353,571. To make sure your answer is correct, add up the 70% and 30% values and if they make the original total value, then the answer is correct. $825,000 + $353,571 = $1,178,571