Shareholders receive dividends — a portion of the current company profits — by investing in the shares of a company. This can be done in many different ways, including receiving additional stock or cash payments. The board of a company decides the dividend payouts and follows a certain dividend policy to determine the same.
Dividends are appealing to investors because they provide a regular stream of income. Usually, they are paid quarterly (in line with the company’s earnings reports). But, in certain instances, a company may choose to pay special or irregular dividends. This article focuses on the meaning of the residual dividend policy.
Residual Dividend Policy
Residual dividends is a dividend policy adopted by certain companies, wherein the amount of dividends paid to shareholders is equal to the profit amount left after the company has paid its capital expenditure (CapEx) and its operating costs (working capital).
Companies that use a residual dividend policy are essentially funding their CapEx with available earnings before paying dividends to shareholder. This means that the dividend amount paid to investors each year differs.
Companies with a residual dividend policy hold zero excess cash at any given point in time. All spare cash is either reinvested in the business or distributed amongst the shareholders.
Imperfections in the capital market make it very rare for businesses to follow purely a residual dividend policy. Most businesses follow a smooth dividend policy that calls for regular dividends, representing some correlation with the company’s historical and present earnings.
How does a residual dividend policy work?
A residual dividend policy dictates that a company first uses its earnings to pay for its capital expenses; after that, the dividends will be paid from the remaining income. The capital structure of a company typically includes both long-term debt and equity. CapEx can be financed by acquiring more loans (debt) or by issuing more shares (equity).
Shareholders can accept management's strategy of using profits to fund capital investments. However, the investment community analyzes how well the company spends on capital to generate more income. The return on assets (ROA) formula is net income divided by total assets, and ROA is a common tool for assessing management performance.
If an apparel manufacturer decides to spend INR 100,000 on capital expenditure, the company can increase production and run machines at a lower cost — both of which can increase profits. As net income increases, the return on assets will increase and shareholders may be more willing to accept future residual dividend policies. However, if the firm generates lower earnings and continues to fund its capital expenditure at the same rate, shareholder dividends decline.
Example of the residual dividend model
To understand the definition of residual dividend policy, consider a company ABC Ltd with a share capital of INR 8,000,000. ABC Ltd follows a 60-40 debt-equity ratio that they want to maintain going forward. The company generates a net income of INR 5,000,000. The business reports total equity of INR 3,200,000 (Total Equity = 40% of INR 8,000,000 = INR 3,200,000). The residual dividend paid is INR 1,800,000 (INR 5,000,000 – INR 3,200,000). The business, therefore, shows a payout ratio of 36% (INR 1,800,000/INR 5,000,000).
Consider the following alternatives:
- Scenario 1: ABC Ltd’s net income falls to INR 3,000,000. The total equity of the business is INR 3,200,000, the entire amount is therefore retained. Dividends paid and the dividend payout ratio are nil.
- Scenario 2: ABC Ltd’s net income increases to INR 8,000,000. The total equity of the business is INR 3,200,000 and INR 4,800,000 (INR 8,000,000 – INR 3,200,000 = INR 4,800,000) is paid out as dividends. The dividend payout ratio is therefore 60% (INR 4,800,000/INR 8,000,000).
Advantages and disadvantages of a residual dividend policy
A residual dividend policy generally requires fewer stock issues and lower floatation costs. However, a variable dividend policy can conflict with investors. Additionally, it represents an increased level of risk for investors, as their dividend income remains uncertain.
Requirements for a residual dividend policy
When a company makes a profit, it can either retain the profit for working capital needs or pay shareholders a profit as a dividend. Retained earnings are used to fund ongoing businesses or to purchase assets. Every business needs assets to function, and they may need to be renewed and eventually replaced over time. Company management must consider the assets needed to run the company, as well as the need to reward shareholders by paying dividends.
In the case of the residual dividend policy, the dividend-irrelevance theory is assumed to be true. This theory states that investors are not concerned so much about the form of profit they get from the company — be it dividends or capital gains. According to this theory, investors value dividends and capital gains equally, so the residual dividend policy does not impact the market value of the company. The residual dividends are calculated passively.
Final word
The residual dividend policy is considered to be more efficient than a smooth dividend policy. If at any point in time, a business can’t find profitable investments, then it should return cash available to shareholders, for use at their discretion.
