Question

What are some drawbacks to following a strict residual dividend policy? What do firms typically do in practice?

Please explain thoroughly.

Answer 1

Meaning of Residual Dividend & Residual Dividend Policy & Practice:

Residual means the left part of the dividend. A company's residual dividend is that part of the dividend which is left after paying the capital expenditures. This type of dividend is volatile(not-fixed) because the payment of dividend is not fixed by the company. The Company Policy which has provision to pay residual dividend is called Residual Dividend Policy. In simple words, when all the business expenditures have made and the money is left, this money is paid to shareholders, its the money called residual dividend.

The Companies can use the retained earnings in the form of working capital or by buying long term assets. Some people refer retained earnings as ploughing back of profits in a firm.

Reasons Companies Practice Residual Dividend Policy:

1. To Maximise Company's Value: According to Dividend's Relevance theory, the company should use that dividend policy which can maximise firm's value (maximisation of profits). In this policy, all the expanses have been met by the company and dividend is paid at the end so a company can maximise its value by residual dividend policy.

2. To Minimise risk of non payment of fixed expanses: Sometimes companies have fixed expenses like repayment of loans/ debt or fixed amount of interest/ tax. To avoid the failure of payment, company pays all the expenses in advance.  

3. To obtain Clear picture of Net Profit: The Net Profit Obtained by paying off all sorts of expenses is the purest profit. A company can get a very clear picture of its net profits by using this policy.

Drawbacks of Residual Dividend Policy:

1. Volatility in Dividends: The dividends are not fixed or volatile. In case of sufficient/higher profits the company is able to pay the dividends, but if there are not enough profits the company is not able to pay the dividends.

2. Dissatisfaction of Shareholders: The shareholders become dissatisfied because of irregular receipts of dividends.

3. Doesn't Maximise Shareholder's Wealth: Its a traditional policy which maximises company's wealth but not shareholders'. In this policy, company's sufficiency matters more than shareholders' satisfaction.

Conclusion:

Residual Dividend policy increases the supply of funds to a company by paying all sorts of expenses. It also decreases the need to issue new equity and its flotation cost as well but in shareholders' point of view it is not the optimum policy because their payment of dividend is not fixed. Shareholders are the real owners of a company and their satisfaction is a matter of concern. This policy is best for government companies but a private company should maintain an optimum dividend payment policy where maximisation of company and maximisation of shareholders' wealth go hand in hand. A company can maintain a policy where it can decide a least/ minimum rate/percentage of dividend to be paid even if there are insufficient profits to maintain the trust and a minimum income of its shareholders.