Question

1. You are the CEO of “I am the top 1%” Corporation, which has a capital structure of 60% equity and 40% debt. The estimated net income of your company is $600K. Your capital budget is $800K for the coming year. If you follow the residual dividend models, how much dividend you can pay and what is your pay-out ratio? What happens to dividend when estimated net income is $400K or $800K?
2. Discuss the advantages and disadvantages of Residual dividend policy.
3. What are the steps you consider in setting your dividend policy?
4. Explain the concept of DRIP with an example.

Answer 1

i) A residual dividend policy is where the companies fund capital expenditure through available earnings before distributing the remaining earnings as dividends.

If the capital budget is 800K, the company will fund the equity portion from the profit. So 60% of the project is funded from equity which is 480K (0.60 * 800) This amount will be deducted from 600K profits and the remaining 120K will be distributed as dividends to the shareholders. For the project the remaining 40% which is 320K will be raised through debts.

ii) There are few advantages of the residual dividend policy. These are suited best for the company where they prioritize projects for the company rather than givings dividends. They believe in growth opportunities with projects rather than sharing profits as dividends. These policies are used when the companies want to upgrade the facilities, expand their business, upgrading of existing facilities, research and development of a new product and market etc.

There are few disadvantages of this policy also: dividends keep on fluctuating and the management needs to answer the shareholders for constant changes in the dividend payout of the firm. Its not a good option for investors looking for dividend income

iii) There are various steps in which we decide the dividend policy: prospects of the future project, type of industry we are operating in, investors we want to attract: either growth or value investment preferred.

iv) DRIP is a Dividend reinvestment plan is a plan where the company follows a policy of reinvesting the dividend amount into its own stock. It can be made in two ways: cash investment and stock investment. In cash investment the company offers cash to the existing shareholders to buy the stock of its own company. For example the company has $1000 in a year as dividend, they will purchase stocks worth 250 every quarter from the existing shareholders and the amount of dividend goes as investment into the equity. This will raise the shareholders wealth. It can also be done through share-transfer. where the shareholders are made registered shareholder rather than beneficial shareholder where they can transfer the shares through proxy. These are the two ways for DRIP