Question

The residual dividend policy approach is based on the theory that a company’s optimal distribution policy is a function of its target capital structure, the investment opportunities available to the firm, and the availability and cost of its external capital. The firm makes distributions to its shareholders based on its residual earnings.

Consider the following example:

Smith & Jones Company is expected to generate $1,800,000 in net income over the next year. Smith & Jones Company has forecasted a capital budget of $86,000, and it wishes to maintain its current capital structure of 70% debt and 30% equity. If Smith & Jones follows a strict residual dividends policy and makes distributions to its shareholders in the form of dividends, its expected dividend payout ratio for this year will be (69%, 98.57%, 103.5%, 108.43%)   .

If Smith & Jones 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 & Jones will pay out in dividends this year will decrease.

The amount that Smith & Jones will pay out in dividends this year will increase.

Most firms have earnings that vary considerably from year to year and do not grow at a reliably constant pace. Furthermore, their required investment may change often. Which of these statements is the most accurate?

A residual dividend policy can’t be of any help to most firms.

Most firms can still use the concepts behind a residual dividend policy to make long-run decisions about dividends.

Answer 1

The capital budget is $86000.

out of whch equity part is 30%, which comes to = 30% of 86000 = $25800

so ouf o earnings of $1800000, $25800 will be kept for capital budget & remaining will be distributed as dividend.

so dividend pay out ratio = dividend paid/total earnings*100 = (1800000 - 25800)/1800000*100 =98.57%

so answer is 98.57%

If Smith & Jones 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?

correct answer : The amount that Smith & Jones will pay out in dividends this year will increase.

If less amount is forecasted for capital budget, then more amount is available for dividend payout, so obviously, dividend will increase.

Most firms have earnings that vary considerably from year to year and do not grow at a reliably constant pace. Furthermore, their required investment may change often. Which of these statements is the most accurate?

correct answer :Most firms can still use the concepts behind a residual dividend policy to make long-run decisions about dividends.