Residual Dividend Model - YouTube

In this video I discuss the residual dividend model. under the residual

dividend model a company pays out whatever income it doesn't need to

invest in new projects and keep its current capital structure; therefore,

dividends equal the net income minus retained earnings to finance new

projects. The retained earnings to finance new projects is going to be

calculated by the target capital ratio times their

new capital budget. This is commonly written as the equity fraction (ws) for

the company times the capital budget (CB). The company's equity fraction (ws)

plus the debt fraction (wd) must add up to 1.

Dividends can also, of course, be calculated as net income minus retained

earnings. For example we are going to consider a company with a net income of

$10,000,000 with a target equity fraction of 60% and a capital budget of

$3,000,000. Their retained earnings that is required is therefore

going to be the 0.6 times the $3,000,000 or $1.8 million dollars. The dividends that can then be paid out will be the net income

of $10,000,000 minus the retained earnings of $1.8 million or

$8.2 million can be paid out in dividends. If this is the number of

shares the company has outstanding, then the dividends per share will merely be

the dividends divided by the number of shares, or 82 cents per share.

Since economic conditions vary from year to year, the net income of the company

tends to fluctuate. What if it was $10 million the first year but goes up to $12

million the next year, and down to $7 million the year after that.

Under each of these conditions the company would need

$1.8 million in retained earnings to finance new

projects, but the dividends paid out would fluctuate quite a bit because the

net income has changed and the extra money the company does not need to

finance expansion changes. If the net income goes up to $1.2 million

the retained earnings stays the same, but the dividends (which again are going to

be net income minus retained earnings) now go up to $10.2 million or a

$1.02 a share. In the final case the net income has dropped

substantially, the retained earnings stay the same, so the dividends decrease again

and reduce net income minus retained earnings to $5.2 million are only $0.52

per share. Time period to time period what a dividend recipient

receives changes drastically. You can see this on the graph. Dividends go up or

down. People commonly invest in dividends for the purpose of income to retire off

of -- paying their rent are their daily living expenses. There really is no

clientele for a drastically fluctuating dividend payout. This is why companies

tend to not use the residual dividend policy, but they might calculate it to

figure out (based on past earnings) what the minimum dividend they can

easily pay out. Then they might look around that range and keep that as a

constant dividend. I thank you for watching this video.