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A B C D E F G
14 Chapter model 12/12/2018
ESTABLISHING DIVIDEND POLICY IN PRACTICE (Section 14-3)
These factors are combined into what has become the residual dividend model. Within the
residual dividend model, firms must determine the optimal capital budget, determine the
The optimal payout ratio for a firm is a function of four factors: (1) Investors’ preferences for
dividends versus capital gains, (2) the firm’s investment opportunities, (3) the firm’s target
capital structure, and (4) the availability and cost of external capital.
The return on a stock consists of two elements, dividends and capital gains. In rate of return
terminology, the total return consists of a dividend yield plus a capital gains yield, the g term
in the following equation:
If a company increases its dividend payout, that raises the numerator of the stock price
equation, D1, and that tends to increase the stock price. However, raising the dividend will
lower the amount of earnings available for reinvestment, and thus it will lower the growth
rate, which will tend to lower the stock price. (Under certain conditions, g = (1 −
Chapter 14. Distributions to Shareholders: Dividends and Share
Repurchases
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PROBLEM
Net Income $60
Dividends =
Net Income − [(Target equity ratio) × (Total capital budget)]
Cap Bud $36 60.0% Cap Bud $36 60.0%
Consider a firm whose net income for the current year is $60 million, their target equity ratio
is 60%, and the expected capital budget is $40 million. What are its dividends to be paid,
according to the residual model?
Dividends and Payout at Different
Capital Budgets: Raw Data
Dividends and Payout at Different Capital
Budgets: Constrained by IF Statement
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A B C D E F G H
SECTION 14-3 12/12/2018
SOLUTIONS TO SELF-TEST QUESTIONS
Capital budget $30,000,000
6. A firm has a capital budget of $30 million, net income of $35 million, and a target capital structure
of 45% debt and 55% equity. If the residual dividend policy is used, what is the firm’s dividend payout
ratio?
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A B C D E F G H
SECTION 14-6 12/12/2018
SOLUTIONS TO SELF-TEST QUESTIONS
Shares 100
EPS $4.00
5. Suppose you have 100 common shares of Tillman Industries. The EPS is $4.00, the DPS is $2.00,
and the stock sells for $60 per share. Now Tillman announces a 2-for-1 split. Immediately after the
split, how many shares will you have, what will be the adjusted EPS and DPS, and what would you
expect the stock price to be?