3. The residual dividend model

The residual dividend policy approach to dividend policy is based on the theory that a firms optimal dividend distribution policy is a function of the firms target capital structure, the investment opportunities available to the firm, and the availability and cost of external capital. The firm makes distributions based on the residual earnings.

Consider the case of Yellow Duck Distribution Company:

Yellow Duck Distribution Company is expected to generate $200,000,000 in net income over the next year. Yellow Duck Distribution Company has forecasted a capital budget of $83,000,000, and it wishes to maintain its current capital structure of 70% debt and 30% equity.

If the company follows a strict residual dividend policy and makes distributions in the form of dividends, what is its expected dividend payout ratio for this year?

- 74.42%

- 78.80%

- 70.04%

- 87.55%

If Yellow Duck Distribution Company increases its debt ratio, then its dividend payout ratio will (increase or decrease) , assuming that all other factors are held constant.

Orange Marmot Manufacturing Company has very stable, predictable earnings, but its capital investment tends to be lumpy. That means that its required capital budget usually is relatively low, but every few years some large expenditures cause the firms capital budget to be quite large. Orange Marmot Manufacturing Company (should/should not) follow a strict residual dividend policy.