The residual dividend policy approach to dividend policy is based on the theory

Question

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 Inc.: Yellow Duck Distribution Inc. is expected to generate $140,000,000 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 Yellow Duck Distribution is considering using more equity and less debt in its capital structure. Which of these statements best describes how this will affect the firm's annual dividend, assuming that all other factors are held constant? O Yellow Duck Distribution will pay a smaller annual dividend if it goes forward with this decision. O Yellow Duck Distribution's annual dividend will be greater if it goes forward with this decision 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? O The firm's dividends O The firm's earnings

Explanation / Answer

Residual dividend policy is type of dividend policy in which first company use its earnings for the capital investment in current. The amount remained after fulfilling all the obligation of capital investment, pays to shareholder as dividend.

a.

Net Income = $140 million.

Weight of debt = 40%

Weight of equity = 60%.

Maximum capital budget it can support from Net Income is calculated below:

Maximum Capital Budget = $140 / 60%

                                              = $233,33 Million.

Maximum Capital budget is $233.33 Million.

b.

Id company wants to use more equity and less debt in its capital structure and for new project. So company will less dividend, since, most of its income is used in capital project.

Statement (A)is correct answer.

c.

Firms earnings graph is more stable than firm dividend graph. Since dividend payment in 20 year change according to availability of projects.

Option (B) is correct answer.

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