3. The residual dividend model Aa Aa The residual dividend policy approach is ba
ID: 2759509 • Letter: 3
Question
3. The residual dividend model Aa Aa 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: ABC Telecom Inc. has generated earnings of $140 million. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $88 million on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure. The company makes distributions in the form of dividends. 60% 40% > Equity Debt What will ABC Telecom Inc.'s dividend payout ratio be if it follows a residual dividend policy? | | If ABC Telecom Inc. increases its debt ratio, its dividend payout ratio will factors are held constant ,assuming that all other Globex Corp. 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. Globex Corp. follow a strict residual dividend policy.Explanation / Answer
a)
Earnings/Net Income = $140,000,000
Equity Capital = $88,000,000 × 60% = $52,800,000
Debt Capital = $88,000,000 × 40% = $35,200,000
As dividends paid are not given in this problem. We can assume that dividends are paid from the Earnings in the form of Equity capital. Companies using residual dividend policy chose to rely on internally generated equity to finance any new projects. So, dividends come out of the residual equity after all project requirements are met.
Dividend Pay out Ratio = Total Dividends / Net Income [ Total Dividends = $140,000,000 - $52,800,000 = $87,200,000]
= $87,200,000/$140,000,000
= 0.62285 or 62.285%
b) If ABC Telecom increases it debt-ratio, the dividend payout ratio will increase assuming that all other factors are held constant.The higher dividend increases the debt-ratio in two ways.
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