The residual dividend model
5. The residual dividend model Aa Aa 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 Group: Yellow Duck Distribution Group is expected to generate $180,000,000 in net income over the next year. Yellow Duck Distribution's stockholders expect it to maintain its long-run dividend payout ratio of 40% 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 If Yellow Duck Distribution Group reduces the amount of its forecasted capital budget, how will this affect the firm's annual dividend, assuming that all other factors are held constant? The amount that Yellow Duck Distribution will pay out in dividends this year will decrease. The amount that Yellow Duck Distribution will pay out in dividends this year will increase. Orange Marmot Manufacturing Corporation has very stable, predictable earnings, but its capital investment tends to be lumpy. That means that its required capital budget usually is relatively low, but every few years some large expenditures cause the firm's capital budget to be quite large. Orange Marmot Manufacturing follow a strict residual dividend policy. What kind of company is most likely to follow a strict residual dividend policy? A firm whose investment needs change often A firm with stable, predictable earnings and investment A firm with highly variable earnings and investment All companies 5. The residual dividend model Aa Aa 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 Group: Yellow Duck Distribution Group is expected to generate $180,000,000 in net income over the next year. Yellow Duck Distribution's stockholders expect it to maintain its long-run dividend payout ratio of 40% 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 If Yellow Duck Distribution Group reduces the amount of its forecasted capital budget, how will this affect the firm's annual dividend, assuming that all other factors are held constant? The amount that Yellow Duck Distribution will pay out in dividends this year will decrease. The amount that Yellow Duck Distribution will pay out in dividends this year will increase. Orange Marmot Manufacturing Corporation has very stable, predictable earnings, but its capital investment tends to be lumpy. That means that its required capital budget usually is relatively low, but every few years some large expenditures cause the firm's capital budget to be quite large. Orange Marmot Manufacturing follow a strict residual dividend policy. What kind of company is most likely to follow a strict residual dividend policy? A firm whose investment needs change often A firm with stable, predictable earnings and investment A firm with highly variable earnings and investment All companies
