Residual Dividend Policy

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An Example: The Residual Dividend Model

In the chapter we discussed the problem with strict adherence to the dividend residual model. In practice, companies use the residual dividend model to develop an understanding of the determinants of an optimal dividend policy, but they typically use a computerized financial forecasting model when setting the target payout ratio. Most larger corporations forecast financial statements over some horizon (usually 5 to 10 years). Projected capital expenditures and working capital requirements are entered into the model, along with sales forecasts, profit margins, depreciation, and the other elements required to forecast cash flows. The target capital structure is also specified, and the model shows the amount of debt and equity that will be required to meet the capital budgeting requirements while maintaining the firm’s target capital structure. From all these data, the funds available for shareholder distribution can be determined. Table 15A-1 illustrates how Langdon Trading Inc. combines the forecasting model and the residual dividend model to determine its

TA B L E 1 5 A - 1

Long-Run Residual Dividend Model Forecast



Web Appendix 15A An Example: The Residual Dividend Model

payout policy. This spreadsheet is provided in the model developed for this chapter—just click on the tab labeled Web Appendix 15A. Langdon’s analysts have made the assumptions shown and estimated the firm’s expected earnings and required assets over the next five years. In Langdon’s case, the required new investment represents the capital the firm must invest to fund its future capital budget. The firm expects its assets, in general, to grow at 12 percent, which its initial forecast reflected. In a subsequent forecast, Langdon recognized a very large expenditure needed in the third year so it added this investment ($200 million) to the Year 3 total assets. Hence, the investment in Year 3 is far greater...
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