Residual Dividend Model and Residual Dividend Policy (Plan)

Residual Dividend Model

Capital Structure
Debt			40%
Equity			60%
Income Statement items
Estimated net income (also retained earnings)		at the end of current year	$153 million
Fund raising for the planned net instments
Planned net investments		In the current year	$160 million
Fund raised		by debt	160*40%=$64 millon
Fund raised		by equity (retained earnings)	160*60%=$96 millon
Retained earnings
Net investments			$96 millon
Dividends		(residual after the net investments)	153-96=$57 million
Dividend payout ratio			57 / 153 = 37.25%

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Residual Dividend Policy (Plan)

1. A firm determines the optimal capital budget.
2. Uses retained earnings to fund the optimal capital budget, paying out what is left over to shareholders.
3. Because the amount of distributable earnings is not known in advance and is determined as a function of the capital budget, the dollar dividend paid to shareholders will fluctuate widely from year to year.
4. However, the firm will be able to use internally generated funds to a greater extent when deciding how to fund the optimal capital budget.
5. It is NOT true, however, that the redisual dividend policy will reduce the firm's cost of capital. Investors do not like unpredictable dividends and will penalize the company in the form of a higher required return on equity to compensate for the additional uncertainty related to dividend payments.