What is Residual Dividend Policy?
The residual dividend policy refers to the dividend policy where a company can distribute or can not distribute its earnings as dividends. This dividend policy suggests that the corporate firm should retain earnings as long as it has investment opportunities. Under this dividend policy, the dividend distribution to the company’s shareholders is based on the future investment opportunities and a debt-equity ratio of the firm.
Understanding Residual Dividend Policy
Residual dividend policy suggests that a firm should retain its earnings as long as it has investment opportunities that promise a higher rate of return than the shareholder’s required rate of return. In other words, under this dividend policy, a firm pays dividend only after meeting its investment need at the desired debt-equity ratio.
Let’s suppose a firm has sufficient earnings. Following this dividend policy, if the firm has better investment opportunities it can retain its all earnings as much as possible. Similarly, if a firm has not any investment opportunities in the near future it can distribute its earnings as dividends, which is a residual dividend.
See also the video on this dividend policy or model,
This dividend policy is based on the assumption that,
- The firm wishes to minimize the need for external equity, and
- Similarly, the firm wishes to maintain its current capital structure.
The firm, therefore, depends on internally generated equity to finance new projects with positive net present value and dividends are paid out from residual income that is left after meeting equity financing requirements. If the net income exceeds the portion of equity financing, then the excess of net income over equity needs is paid as a dividend. The company does not pay any dividend when net income is less than or equal to the equity need for the financing investment proposal. In case net income is inadequate to meet the equity portion, the company should raise the deficit amount by issuing new shares. Thus, residual dividend policy implies that dividends payments will vary from year to year, depending on available investment opportunities and debt-equity ratio.
Amount of dividend under this dividend policy
Under the residual dividend policy, the amount of dividend is computed using the following equation,
Amount of dividend = NI – E1
Where NI is net income and E1 is equity financing required for the new projects. The firm pays a dividend if the net income exceeds the amount of equity financing, otherwise, it does not.
How to calculate Residual Dividend Policy?
After understanding what is residual dividend policy, we also have to know about how a firm uses this dividend policy in its operations to calculate dividends and dividend payout ratio.
Let’s clarify it through an example,
Spice Nepal Company Limited has a target capital structure, which consists of 70% debt and 30% equity. The company anticipates that its capital budget for the upcoming year will be Rs 3,000,000. If the company reports net income of Rs 2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio?
The proportion of debt in financing = 70%, Proportion of equity in financing = 30%, Investment amount or Target capital budget = Rs 3,000,000, Net income = Rs 2,000,000
Calculation of the dividend amount
Dividend = Net income – Portion of equity in financing = Rs 2,000,000 – Rs 900,000 (i.e. 30% of 3,000,000) = Rs. 1,100,000
Dividend payout ratio = Amount of dividend/ Net income = Rs 1,100,000/ Rs 2,000,000 = 0.55 or 55%
Hence, under the residual dividend policy the Spice Nepal Company Limited has 55% of dividend payout ratio for its shareholders.