Reference no: EM132783423

Royal Industries has for many years enjoyed a moderate but stable growth in sales and earnings. In recent years, it is facing a stiff competition in its plastic product line and, consequently, its sales have been declining. Apprehending further decline in its sales, its management is planning to move eventually out of plastic business altogether and develop new diversified product line in growth-oriented industries. To execute the proposed investment plan of this year, a capital outlay of Rs 12 crore is necessary to purchase new facilities to start manufacturing a new product; the estimated rate of return on fresh investment is 20 per cent. The company has been paying a dividend of Rs 1.50 per share on 4 crore outstanding equity shares. The dividend policy has been to maintain a stable rupee dividend, raising it only when it appears that earnings have reached a new, permanently higher level. The directors may change such a policy if there are compelling reasons to do so. Total earnings of the current year are Rs 10 crore. The current market price of the equily share is Rs 15 and the firm's current leverage ratio (debt/assets) is 40 per cent. Current costs of various forms of financing are:

Debentures, 13 per cent

New equity shares sold at Rs 15 to yield, Rs 14.

Required rate of return on equity, 10 per cent (a) What would be an appropriate dividend policy for Royal Industries? (b) What assumptions, if any, do you make in your answer about investors' preference for dividends versus capital gains?