4. The residual dividend model The residual distribution policy approach to dividend policy is based on...

Transcribed Image Text:

4. The residual dividend model The residual distribution policy approach to dividend policy is based on the theory that a firm's optimal dividend distribution policy is a function of the firm's target capital structure, the investment opportunities available to the firm, and the availability and cost of external capital. The firm makes distributions based on the residual earnings. Consider the case of Yellow Duck Distribution Company: 40% Debt 60% Equity Yellow Duck Distribution Company has generated earnings of $240,000,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $88,000,000 on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure. The company makes distributions in the form of dividends. What will Yellow Duck Distribution's dividend payout ratio be if it follows a residual distribution policy? 78.00% 81.90% 46.80% 62.40% If Yellow Duck Distribution Company reduces the amount of its forecasted capital budget, how will this affect the firm's annual dividend, assuming that all other factors are held constant? The amount that Yellow Duck Distribution will pay out in dividends this year will decrease. O The amount that Yellow Duck Distribution will pay out in dividends this year will increase. What kind of company is most likely to follow a strict residual distribution policy? A firm with stable, predictable earnings and investment O All companies OA firm with highly variable earnings and investment OA firm whose earnings are cyclical and follow the economy Gaven Industries, which is in the same sector as Yellow Duck Distribution, exhibits very stable and predictable earnings, but its capital investments tend to be lumpy. This means that Gaven's required capital investment spending is usually relatively low, but every few years, some sizable expenditures will cause the firm's capital budget to be quite large. Should Gaven Industries be following a strict residual distribution policy? No Yes 4. The residual dividend model The residual distribution policy approach to dividend policy is based on the theory that a firm's optimal dividend distribution policy is a function of the firm's target capital structure, the investment opportunities available to the firm, and the availability and cost of external capital. The firm makes distributions based on the residual earnings. Consider the case of Yellow Duck Distribution Company: 40% Debt 60% Equity Yellow Duck Distribution Company has generated earnings of $240,000,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $88,000,000 on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure. The company makes distributions in the form of dividends. What will Yellow Duck Distribution's dividend payout ratio be if it follows a residual distribution policy? 78.00% 81.90% 46.80% 62.40% If Yellow Duck Distribution Company reduces the amount of its forecasted capital budget, how will this affect the firm's annual dividend, assuming that all other factors are held constant? The amount that Yellow Duck Distribution will pay out in dividends this year will decrease. O The amount that Yellow Duck Distribution will pay out in dividends this year will increase. What kind of company is most likely to follow a strict residual distribution policy? A firm with stable, predictable earnings and investment O All companies OA firm with highly variable earnings and investment OA firm whose earnings are cyclical and follow the economy Gaven Industries, which is in the same sector as Yellow Duck Distribution, exhibits very stable and predictable earnings, but its capital investments tend to be lumpy. This means that Gaven's required capital investment spending is usually relatively low, but every few years, some sizable expenditures will cause the firm's capital budget to be quite large. Should Gaven Industries be following a strict residual distribution policy? No Yes