3. The residual dividend model The residual dividend policy approach to dividend policy is based on the theory that a firm's optimal dividend distribution policy is a function of the firm's 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 $240,000,000 in net income over the next year. Yellow Duck Distribution Company's stockholders expect it to maintain its long-run dividend payout ratio of 25% of earnings. 40% Equity 60% Debt 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 year's expected net income is Yellow Duck Distribution Company is considering using more equity and less debt in its capital structure. Which of these statements best describes how this will affect the firm's annual dividend, assuming that all other factors are held constant? Yellow Duck Distribution Company will pay a smaller annual dividend if it goes forward with this decision. Yellow Duck Distribution Company's annual dividend will be greater if it goes forward with this decision. 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 can't 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