Residual dividend policy is used by companies, which finance new projects through equity that is internally generated. In this policy, the dividend payments are made from the equity that remains after all the project capital needs are met. This equity is also known as residual equity. It is advisable that those companies, which follow the policy of residual dividend, should maintain a balanced debt/equity ratio. If a certain amount of money is left after all forms of business expenses then the corporate houses distribute that money among its shareholders as dividends.
The companies that follow a
residual dividend policy pay dividends only if other satisfactory opportunities and sources of investment of funds are not available. The main advantage of a
residual dividend policy is that it reduces to the issues of new stocks and flotation costs. The drawback of this policy mainly lies in the facts that such a policy does not have any specific target clients. Moreover, it involves the risk of variable dividends. This policy helps to set a target payout.
Before opting for the policy of residual dividend, the earnings that need to be retained to back up the capital budget have to be calculated. Then, the earnings that are left can be paid out in the form of dividends to the shareholders. Thus, the issue of new equities gets considerably reduced and this in turn leads to reduction in signaling and flotation costs. The amount payable as dividend fluctuates heavily if this policy is practiced. When the total value of productive investments is in excess of the total value of retained earnings and sustainable debt, the companies feel the urge to exploit the opportunities thus created to postpone a few investment schemes.
The
residual dividend policy is more suitable for the government concerns because they mainly aim for creation of value and maximization of wealth and therefore they have to make use of every value added investment opportunity that comes on their way. A little change in the basic postulates of the policy usually occurs when it is applied to the government sector because it takes into its purview the government's liking for dividends rather than capital gains.
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