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 Purple Hedgehog Forestry Group

Purple Hedgehog Forestry Group is expected to generate $180,000,000 in net income over the next year. Purple Hedgehog Forestry Groups stockholders expect it to maintain its long-run dividend payout ratio of 20% of earnings.

If the firm wants to maintain its current capital structure of 60% debt and 40% equity, the maximum capital budget it can support with this years expected net income is .

If Purple Hedgehog Forestry Group reduces the amount of its forecasted capital budget, how will this affect the firms annual dividend, assuming that all other factors are held constant?

-The amount that Purple Hedgehog Forestry Group will pay out in dividends this year will decrease.

-The amount that Purple Hedgehog Forestry Group will pay out in dividends this year will increase.

Most firms have earnings that vary considerably from year to year and do not grow at a reliably constant pace. Furthermore, their required investment may change often. Which of these statements is the most accurate?

-Most firms can still use the concepts behind a residual dividend policy to make long-run decisions about dividends.

-A residual dividend policy cant be of any help to most firms.