Residual Dividend

Definition

A Residual Dividend is a policy where a company pays out dividends to its shareholders from the remaining or ‘residual’ profit after all operating expenses and reinvestment activities have been catered for. Essentially, it’s the leftover profit once all obligations are met. This policy ensures that investments with positive net present value are not overlooked for the sake of paying dividends.

Phonetic

The phonetic pronunciation of “Residual Dividend” would be:Residual: /rɪˈzɪdʒuəl/Dividend: /ˈdɪvɪdend/

Key Takeaways

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Residual Dividend policy is a financial strategy in which a company uses residual or leftover equity to finance dividends. This means that dividends are paid from the remaining funds after all project capital requirements are met.
Under this model, a company prioritizes its investments in business projects and assets. If there are any funds left after such investments, these are paid out as dividends to the shareholders. Therefore, in some periods, shareholders may not receive a dividend if no funds are left over.
The residual dividend policy provides a clear linkage between a company’s long-term investment opportunities and dividends. It can lead to unstable dividends, though it supports the management’s goal of shareholder wealth maximization.

Importance

The Residual Dividend policy is crucial in corporate finance as it determines the amount of earnings that will be distributed to shareholders after all capital expenditures and working capital needs of the firm are met. By using this policy, a company ensures that all essential funds needed for growth, operations, and upcoming projects are set aside first before any distribution of dividends, thereby maintaining the firm’s financial viability and stability. This policy also allows for dividends to fluctuate as they directly depend on the amount of earnings remaining after the firm’s obligations have been met. Hence, Residual Dividend plays a vital role in managing a company’s financial health while balancing the return expectations of shareholders.

Explanation

The primary purpose of a residual dividend policy is to prioritize a company’s internal growth before considering dividend payments. Essentially, this approach helps to ensure that the company invests sufficient funds back into itself to maintain steady growth and expansion, only utilizing remaining, or ‘residual’ , profits to payout to shareholders. Businesses use this policy when they want to reinvest in operations or have expensive upcoming projects that need financing. A company may also establish a residual dividend policy to retain a flexible dividend policy dependent on the earnings it has each year.The residual dividend policy is crucial for companies with significant growth prospects and uncertain future earnings. It enables firms to fund new projects or expansion activities without relying heavily on external sources of finance, such as debt or selling off additional shares. Furthermore, employing a residual dividend policy allows companies to avoid unnecessary borrowing, thereby keeping debt-related costs at bay. However, it is important to note that while this approach can be beneficial in terms of growth and flexibility, it may lead to irregular dividend amounts, which could be unappealing to income-dependent investors.

Examples

1. Microsoft Corporation: Microsoft is a good example of a company that uses the residual dividend model. The tech giant usually prioritizes its financial resources for its expansion, research, and development. This became evident especially in its early years when the company didn’t pay any dividends to its shareholders but later started to pay in 2003, once it had a sustainable profit and financial stability.2. Alphabet (Google): For many years, Google’s policy was to reinvest its net income back into the business for research, development, and acquisitions rather than pay dividends. Asserting a strategy typical of a residual dividend policy, Google opted to accumulate a sufficient financial surplus before deciding to pay dividend to its shareholders. However, even after achieving significant financial growth, Google still does not pay dividends and instead reinvests in business growth.3. Berkshire Hathaway: Warren Buffett’s Berkshire Hathaway Inc. is a classic example of a company that uses residual dividends. Berkshire Hathaway does not pay dividends to its shareholders. Instead, all profits are plowed back into the company’s many subsidiaries or are used to purchase new ones. Buffett has maintained this policy for over 50 years, and it has paid off tremendously for him and his shareholders.

Frequently Asked Questions(FAQ)

What is a residual dividend?

A residual dividend is a policy in which a company pays dividends to its shareholders after all its capital costs/expenses and investments for future growth have been met.

How is a residual dividend calculated?

It is calculated by subtracting the desired capital expenditures and required retained earnings from net income. The remaining amount, or residual amount, is then allocated as dividends to shareholders.

Why do companies adopt a residual dividend policy?

Companies opt for a residual dividend policy as a way to ensure that they can fund their growth with retained earnings before paying out any remaining profits as dividends. This can also aid in maintaining financial stability and flexibility.

How does a residual dividend policy affect shareholders?

This policy can lead to fluctuating and unpredictable dividend payments to shareholders as the amount is directly linked to the company’s profitability and investment choices.

What is the difference between the residual and stable dividend policy?

In a stable dividend policy, companies strive to maintain steady and predictable dividend payouts, regardless of their earnings or capital expenditure needs. In contrast, a residual dividend policy results in dividend payouts that fluctuate based on earnings and reinvestment needs.

Is a residual dividend policy beneficial?

This generally depends on the company’s specific situation. If a company consistently has high capital expenditure, there may be little to no residual dividends. However, this policy can be beneficial for companies with high profitability and low reinvestment needs, ensuring that excess profits are returned to shareholders.

Can a company change its dividend policy from residual to other types?

Yes, a company can change its dividend policy based on its strategic needs, investment opportunities, and the market environment. While a stable or constant dividend policy might be more attractive to investors seeking regular income, a residual policy might be preferable when capital expenditures regularly consume considerable profit.

Related Finance Terms

Dividend Policy: A company’s policy or guidelines for distributing earnings to shareholders in the form of cash distributions or additional shares.
Retained Earnings: The portion of net earnings which are not paid out as dividends but retained by the company to reinvest in its core business or pay debt.
Capital Structure: A mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity, which funds its overall operations and growth.
Investment Opportunities: Potential avenues for companies to invest funds for growth and revenue-generation, affecting the amount of residual dividends.
Payout Ratio: The proportion of earnings paid out as dividends to its shareholders, which impacts what remains as a residual dividend.

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