what is the chief drawback to a strict residual policy what do many firms do in prac 562811

A Compromise Dividend Policy

In practice, many firms appear to follow what amounts to a compromise dividend policy. Such a policy is based on five main goals:

1. Avoid cutting back on positive NPV projects to pay a dividend.

2. Avoid dividend cuts.

3. Avoid the need to sell equity.

4. Maintain a target debt equity ratio.

5. Maintain a target dividend payout ratio.

These goals are ranked more or less in order of their importance. In our strict residual approach, we assume that the firm maintains a fixed debt equity ratio. Under the compromise approach, the debt equity ratio is viewed as a long range goal. It is allowed to vary in the short run if necessary to avoid a dividend cut or the need to sell new equity. In addition to having a strong reluctance to cut dividends, financial managers tend to think of dividend payments in terms of a proportion of income, and they also tend to think investors are entitled to a “fair” share of corporate income. This share is the long run target payout ratio, and it is the fraction of the earnings the firm expects to pay as dividends under ordinary circumstances. Again, this ratio is viewed as a long range goal, so it might vary in the short run if this is necessary. As a result, in the long run, earnings growth is followed by dividend increases, but only with a lag. One can minimize the problems of dividend instability by creating two types of dividends: regular and extra. For companies using this approach, the regular dividend would most likely be a relatively small fraction of permanent earnings, so that it could be sustained easily. Extra dividends would be granted when an increase in earnings was expected to be temporary. Because investors look on an extra dividend as a bonus, there is relatively little disappointment when an extra dividend is not repeated. Although the extra dividend approach appears quite sensible, few companies use it in practice. One reason is that a share repurchase, which we discuss next, does much the same thing with some extra advantages.

CONCEPT QUESTIONS

a What is a residual dividend policy?

b What is the chief drawback to a strict residual policy? What do many firms do in practice?

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