5. The residual distribution model The residual distribution policy approach is based on the theory that a firm's optimal distribution policy is a function of the firm's target capital structure, the investment opportunities that the firm has, and the availability and cost of external capital. The firm makes distributions based on the residual earnings. Consider the following example: Smith and Jones Co. is expected to generate $240 million in net income over the next year. Smith and Jones Co.'s shareholders expect it to maintain its long-run dividend payout ratio of 30% of earnings. If the firm wants to maintain its current capital structure of 60% debt and 40% equity, what is the maximum capital budget it can support with this year's expected net income? 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. Does this mean that the residual distribution policy approach can't be of any help to most firms? Yes No Gaven Industries, which is in the same sector as Smith and Jones Co., has very stable, predictable earnings, but its capital investment tends to be lumpy. This means that its required capital spending is usually relatively low, but every few years, some sizable expenditures cause the firm's capital budget to be quite large. Should Gaven Industries be following a strict residual distributions policy? No Yes 5. The residual distribution model The residual distribution policy approach is based on the theory that a firm's optimal distribution policy is a function of the firm's target capital structure, the investment opportunities that the firm has, and the availability and cost of external capital. The firm makes distributions based on the residual earnings. Consider the following example: Smith and Jones Co. is expected to generate $240 million in net income over the next year. Smith and Jones Co.'s shareholders expect it to maintain its long-run dividend payout ratio of 30% of earnings. If the firm wants to maintain its current capital structure of 60% debt and 40% equity, what is the maximum capital budget it can support with this year's expected net income? Most firms have earnings thal from year to year and do not grow at a reliably constant pace. Furthermore, their required investment may change often. Does this ual distribution policy approach can't be of any help to most firms? Yes No Gaven Industries, which is in the same sector as Smith and Jones Co., has very stable, predictable earnings, but its capital investment tends to be lumpy. This means that its required capital spending is usually relatively low, but every few years, some sizable expenditures cause the firm's capital budget to be quite large. Should Gaven Industries be following a strict residual distributions policy? No Yes