Corporate Finance - Setting Dividends

The residual-dividend model is a model that a company can utilize to set a target dividend payout ratio.

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
Look Out!
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.

Dividend Payment Procedures
Related Articles
  1. Financial Advisors

    Tips on Passing the CFA Level I on Your First Attempt

    Obtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
  2. Financial Advisors

    Putting Your CFA Level I on Your Resume

    Learn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
  3. Professionals

    Investment Analyst: Career Path and Qualifications

    Learn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
  4. Professionals

    CAIA Vs. CFA: How Are They Different?

    Find out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
  5. Professionals

    Equity Investments: CFA Level II Tutorial

    Chapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
  6. Professionals

    What To Expect On The CFA Level III Exam

    The Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
  7. Professionals

    What To Expect On The CFA Level I Exam

    Becoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
  8. Options & Futures

    The Alphabet Soup of Financial Certifications

    We decode the meaning of the many letters that can follow the names of financial professionals.
  9. Professionals

    How to Ace the CFA Level I Exam

    Prepare to ace the CFA Level 1 exam by studying systematically.
  10. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
Trading Center