The residual dividend policy approach is based on the theory that a company’s optimal
distribution policy is a function of its target capital structure, the investment opportunities available to the firm, and the availability and cost of its external capital. The firm makes distributions to its shareholders based on its residual earnings.
Consider the following example:
Allied Biscuit Company has generated earnings of $1,400,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $85,000 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.
Allied Biscuit’s dividend payout ratio will be (72.27% , 81.91% , 96.36% , 106.00) if it follows a residual dividend policy.
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