Residual dividend policy is used by companies, which finance new projects through equity that is internally generated. In this policy, the dividend payments are made from the equity that remains after all the project capital needs are met. This equity is also known as residual equity.
It is advisable that those companies, which follow the policy of residual dividend, should maintain a balanced debt/equity ratio. If a certain amount of money is left after all forms of business expenses then the corporate houses distribute that money among its shareholders as dividends.
The companies that follow a residual dividend policy pay dividends only if other satisfactory opportunities and sources of investment of funds are not available. The main advantage of a residual dividend policy is that it reduces to the issues of new stocks and flotation costs. The drawback of this policy mainly lies in the facts that such a policy does not have any specific target clients.
Moreover, it involves the risk of variable dividends. This policy helps to set a target payout.Before opting for thepolicy of residual dividend, the earnings that need to be retained to back up the capital budget have to be calculated.
Then, the earnings that are left can be paid out in the form of dividends to the shareholders. Thus, the issue of new equities gets considerably reduced and this in turn leads to reduction in signaling and flotation costs. The amount payable as dividend fluctuates heavily if this policy is practiced. When the total value of productive investments is in excess of the total value of retained earnings and sustainable debt, the companies feel the urge to exploit the opportunities thus created to postpone a few investment schemes.
Calculation of Residual dividend policy:
Let’s suppose that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, suppose this company has a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay for one-third of this project by using debt ($300) and two-thirds ($600) by using equity. In other words, the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000 – $600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000 – $1,000) for dividends. If any project required an equity portion that was greater than the company’s available levels, the company would issue new stock
Arguments against Dividends
First, some financial analysts feel that the consideration of a dividend policy is irrelevant because investors have the ability to create “homemade” dividends. These analysts claim that this income is achieved by individuals adjusting their personal portfolios to reflect their own preferences. For example, investors looking for a steady stream of income are more likely to invest in bonds (in which interest payments don’t change), rather than a dividend-paying stock (in which value can fluctuate). Because their interest payments won’t change, those who own bonds don’t care about a particular dividend policy.
The second argument claims that little to no dividend payout is more favorable for investors. Supporters of this policy point out that taxation on a dividend are higher than on a capital gain. The argument against dividends is based on the belief that a firm that reinvests funds (rather than paying them out as dividends) will increase the value of the firm as a whole and consequently increase the market value of the stock. According to the proponents of the no dividend policy, a company’s alternatives to paying out excess cash as dividends are the following: undertaking more projects, repurchasing the company’s own shares, acquiring new companies and profitable assets, and reinvesting in financial assets
Arguments for Dividends
In opposition to these two arguments is the idea that a high dividend payout is important for investors because dividends provide certainty about the company’s financial well-being; dividends are also attractive for investors looking to secure current income. In addition, there are many examples of how the decrease and increase of a dividend distribution can affect the price of a security. Companies that have a long-standing history of stabledividend payouts would be negatively affected by lowering or omitting dividend distributions; these companies would be positively affected by increasing dividend payouts or making additional payouts of the same dividends. Furthermore, companies without a dividend history are generally viewed favorably when they declare new dividends.
The residual dividend policy is more suitable for the government concerns because they mainly aim for creation of value and maximization of wealth and therefore they have to make use of every value added investment opportunity that comes on their way. A little change in the basic postulates of the policy usually occurs when it is applied to the government sector because it takes into its purview the government’s liking for dividends rather than capital gains.