- An analyst gathered the following information about a company’s investment plan: Capital budget of $5,000. Target capital structure is 70% debt and 30% equity. Net income is $4,500. If the company follows a residual dividend policy, the portion of its net income it will pay out as dividends this year is closest to: A. 50%. B. 60%. C. 67%. 30% of $5,000 or $1,500 is equity. $4,500 – $1,500 is $3,000, which as a percent is $3,000 / $4,500 = 67%.
I do not get why we subtract the equity portion and divide the result by the net income to get the dividend payout ratio, is not the remaining amount worth 3000 should be dedicated to debt holders, and the 1500 be the portion of equity out of which dividends are obtained?
So a couple of things here. You never pay out anything to debtholders from net income as your net income is net of all expenses including “interest expense” which is a cash flow to your debtholders. Net income is an investors property or the company’s (it can either pay divs or reinvest it). Now imagine this policy as being similar to residual income with a few minor differences. This is more from a project financing point of view. In the above example, if the company did a net income of 1500 and if the capital raised from equity holders was 1500, the firm would just be breaking even(no value created nor destroyed). However, above the company has reported a net income of 4500 from which if you negate the capital raised via equity, you get to 3000 which is value created. In short, negating 1500 from 4500 is similar to negating an equity charge from your net income to get residual income. Here, the excess that is left after negating the equity portion can be paid out as dividends if the company wants. And that’s why its called a “residual dividend policy”.
Also, the formula for dividend payout ratio is Divs/Net income or DPS/EPS. So thats why do that. Questions asking to calculate the payout ratio.
Hope this helps.