6. The residual dividend model

The residual distribution 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 has generated earnings of $240,000,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $86,000,000 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 Purple Hedgehog Forestrys dividend payout ratio be if it follows a residual distribution policy?

82.43%

58.88%

66.72%

78.50%

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 will pay out in dividends this year will decrease.

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

What kind of company is most likely to follow a strict residual distribution policy?

A firm with stable, predictable earnings and investment

A firm whose investment needs change often

A firm with highly variable earnings and investment

A firm whose earnings are cyclical and follow the economy

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

Dividends

Earnings

Cash flow