The residual-dividend model is based on three key pieces:
1. An investment opportunity schedule (IOS),
2. Target capital structure
3. Cost of external capital
Stockholders' preferences for dividends do not affect the residual-dividend model.
Procedure for the Residual-Dividend Model
1. The first step in the residual dividend model to set a target dividend payout ratio to determine the optimal capital budget.
2. Then, management must determine the equity amount needed to finance the optimal capital budget. This should be done primarily through retained earnings.
3. The dividends then are paid out with the leftover, or residual, earnings. Given the use of residual earnings, the model is known as the "residual-dividend model".
As an example, Newco generates sales of $7 million with earnings of $2 million. The company's optimal capital structure is 50% equity/50% debt. With $2 million in earnings, Newco reinvests the entire amount back into the company. In this case, Newco would have to borrow $2 million to maintain its optimal capital structure.
If Newco, however, needed to reinvest only half of the $2 million back into the company, Newco would then have $1 million in residual earnings to pay dividends. Given the reduced reinvestment, the company would thus have to borrow only $1 million to maintain its optimal capital structure.
Advantage of the Residual-Dividend Model
- With capital-projects budgeting, the residual-dividend model is useful in setting longer-term dividend policy.
Disadvantage of the Residual Dividend Model
- Dividends may be unstable. Earnings from year to year can vary depending on business situations. As such, it is difficult to maintain with certainty stable earnings and thus a stable dividend.
While the residual-dividend model is useful for longer-term planning, many firms do not use the model in calculating dividends each quarter.
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