Question

A firm is planning its next year's dividend payout.
The firm forecasts net income of $12.6M next year.
It anticipates a capital budget of $7.3M next year.
It keeps a debt ratio of 35%
a) How much would the company pay in dividends next year if it follows a residual dividend policy?
b) Suppose the firm pays $2.6M in dividends THIS year. In a concise sentence, explain why the company might choose to pay something closer to this number instead, next year.

Answer 1

a) In residual dividend policy earnings is first attributable towards equity portion of finance required to fund the upcoming projects. Any amount left after such attribution is distributed in the form of dividend.

Anticipated Capital Budget = $7.3M
Debt Ratio = 35%
Equity Ratio = 65%
Capital attributable to Equity = Equity Ratio * Anticipated Capital Budget
                                                          = 65% of 7.3M
                                                          = 4.745M

Dividend = Net Income - Capital attributable to Equity
                = 12.6M – 4.745M
                = 7.855M

b) The company might choose to pay something closer to $2.6M next year because of the concept of stable dividend. The purpose of the stable dividend policy is a predictable dividend payout ratio. With this approach volatility is eliminated which gives more assurance to the shareholder about the amount of dividend to be received. Most of the investors seek certainty and therefore companies opt for a stable dividend policy.