The residual dividend model The residual dividend 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 $200 million in net income over the next year. Smith and Jones Co. has forecasted a capital budget of $88 million, and it wishes to maintain its current capital structure of 70% debt and 30% equity. If the company follows a strict residual dividend policy and makes distributions in the form of dividends, what is its expected dividend payout ratio for this year? If Smith and Jones Co. 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 Smith and Jones Co. will pay out in dividends this year will decrease. The amount that Smith and Jones Co. will pay out in dividends this year will increase. If you were to graph a firm's earnings and dividends over the past 20 years, which would you expect to be the most stable over time? Dividends Earnings