Question

Purple Hedgehog Forestry Corporation has generated earnings of $240,000,000. Its target capital structure consists of 60% equity and 40% debt. Its plans to spend $83,000,000 on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure The company makes distributions in the form of dividends. Purple Hedgehog Forestry is considering using more equity and less debt in its capital structure. Which of these statements best describes how this will affect the firm's annual dividend, assuming that all other factors are held constant?
a.Purple Hedgehog Forestry will pay a smaller annual dividend if it goes forward with this decision.
b.Purple Hedgehog Forestry's annual dividend will be greater if it goes forward with this decision.

Answer 1

Answer:

b. Purple Hedgehog Forestry's annual dividend will be greater if it goes forward with this decision.

Explanation:

In any company, interests on debts must be paid before dividend is paid. This implies that the higher the amount of debt, the will be the interest on debt to pay; and the lower will be the amount that will be left to pay dividend assuming that all other factors are held constant. Also, the lower the amount of debt, the lower will be the interest on debt to pay; and the greater will be the amount that will be left to pay dividend assuming that all other factors are held constant.

Based on the above explanation, Purple Hedgehog Forestry's annual dividend will be greater if it goes forward with this decision.