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 Yellow Duck Distribution Inc.:

Yellow Duck Distribution Inc. is expected to generate $200,000,000 in net income over the next year. Yellow Duck Distributions stockholders expect it to maintain its long-run dividend payout ratio of 25% of earnings.

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 years expected net income is .

Yellow Duck Distribution 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?

Yellow Duck Distributions annual dividend will be greater if it goes forward with this decision.

Yellow Duck Distribution will pay a smaller annual dividend if it goes forward with this decision.

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

All companies

A firm whose earnings are cyclical and follow the economy

A firm with highly variable earnings and investment

A firm with stable, predictable earnings and investment

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?

Cash flow

Dividends

Earnings