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 Red Bison Petroleum Producers Group:

Red Bison Petroleum Producers Group has generated earnings of $180,000,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $88,000,000 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.

What will Red Bison Petroleum Producers Groups dividend payout ratio be if it follows a residual dividend policy?

63.60%

56.54%

74.20%

70.67%

Red Bison Petroleum Producers Group is considering using more equity and less debt in its capital structure. Which of these statements best describes how this will affect the firms annual dividend, assuming that all other factors are held constant?

Red Bison Petroleum Producers Group will pay a smaller annual dividend if it goes forward with this decision.

Red Bison Petroleum Producers Groups annual dividend will be greater if it goes forward with this decision.

If you were to graph a firms earnings and dividends over the past 20 years, which would you expect to be the most stable over time?

The firms dividends

The firms earnings