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 $88,000,000, 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?

91.14%

86.80%

95.48%

69.44%

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

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?

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

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