Question #13

0.35 + (1 − 0.35)(0.20) = 48% (Module 15.1, LOS 15.f) Rainham Inc. has never paid a dividend from the cash flows it generates from its projects; rather it likes to reinvest them in growing the business. Rainham Inc. has experienced a period of sustained growth but management is of the opinion that this growth rate will moderate and they have therefore decided to move to a dividend pay-out. The company's cost of equity is currently estimated to be 16%, with the industry's cost of equity at around 12%. The firm has set the objective of achieving a 70% pay-out ratio. The board of directors of Rainham Inc. is worried about the impact of moving immediately to a 70% pay-out ratio; whilst this remains their long term objective they feel that a gradual build-up of the pay-out ratio to 70% would be more appropriate. The proposal is to set an initial dividend pay-out ratio in year 1 of 30% and then increase this over the following five years to 70%. Rainham Inc. has set a growth rate in earnings consistent with their long run ROE and target pay-out ratio. The Commercial Director of Rainham Inc. believes that the board is overly concerned about investors' reaction to the change in dividend policy. He believes that dividend policy is influenced by the availability of investment opportunities, the future volatility of earnings, flotation costs and legal restrictions.