The Topic Residual Dividend Policy is Relevant for UGC NET Commerce & Management as Follows:

Introduction

Every company needs assets to operate, and those assets may need to be upgraded over time and eventually replaced. When a business generates earnings, the firm can either retain the earnings for use in the company or pay the earnings as a dividend to stockholders. Retained earnings are used to fund current business operations or to buy assets.

Residual Dividend Policy

Residual dividend is used when calculating the dividends to be paid to shareholders. Companies fund capital expenditures with available earnings before paying dividends to shareholders. The first priority for a company using residual dividend policy is to use earnings to cash flow capital expenditures, and dividends are paid with any remaining earnings generated by the firm.

Example for Residual Dividend Policy

A firm has Rs.18 Lakhs in available earnings. It needs Rs.15 Lakhs to fund a new investment and the target equity ratio is 70%.

Calculate how much will it pay in dividends and the payout ratio

Net income                                              Rs. 1,800,000

Needed for investment                       Rs. 1,500,000

Equity needed@ 70%                           Rs. 1,050,000

Dividend (NI – equity needed)          Rs. 750,000

Dividend payout ratio

(Dividend / NI)                                         41.7%

Process of Residual Dividend Policy

The following steps determine the payout ratio to be implemented :

  • The optimal capital budget is identified.
  • The equity required to finance the identified capital budget under a given capital structure is determined
  • The remaining amount is calculated for dividend

Practice Question

If a firm maintains its preferred debt-equity ratio and pays dividends only after meeting its investment needs, the firm is following a dividend policy which is referred to as a_____ dividend policy.

A. Stable

B. Residual

C. Constant

D. Remainder

Solution : B

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