14-6. One position expressed in the financial literature is that firms set their

Question

14-6. One position expressed in the financial literature is that firms set their dividends as a residual after using income to support new investment.

Explain what a residual dividend policy implies, illustrating your answer with a table showing how different investment opportunities can lead to different dividend payout ratios.

Think back to chapter 13 where we considered the relationship between capital structure and the cost of capital. If the WACC-versus-debt-Ratio plot was shaped like a sharp V, would this have a different implication for the importance of setting dividends according to the residual policy than if the plot was shaped like a shallow bowl (Flattened “U”)?

Explanation / Answer

The term residual dividend refers to a method of calculating dividends. A dividend is a payment made by a company to its shareholders. It is essentially a portion of the company's profits that is divided amongst the people who own stock in the company. A residual dividend policy is one where a company uses residual or leftover equity to fund dividend payments. Typically, this method of dividend payment creates volatility in the dividend payments that may be undesirable for some investors

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