Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

18. Dividends and Dividend
    Policy

© The McGraw−Hill^647

Companies, 2002

In Row 1, for example, note that new investment is $3,000. Additional debt of $1,000

and equity of $2,000 must be raised to keep the debt-equity ratio constant. Because this

latter figure is greater than the $1,000 in earnings, all earnings are retained. Additional

stock to be issued is also $1,000. In this example, because new stock is issued, dividends

are not simultaneously paid out.

In Rows 2 and 3, investment drops. Additional debt needed goes down as well, be-

cause it is equal to^1 ⁄ 3 of investment. Because the amount of new equity needed is still

greater than or equal to $1,000, all earnings are retained and no dividend is paid.

We finally find a situation in Row 4 in which a dividend is paid. Here, total invest-

ment is $1,000. To keep the debt-equity ratio constant,^1 ⁄ 3 of this investment, or $333, is

financed by debt. The remaining^2 ⁄ 3 , or $667, comes from internal funds, implying that

the residual is $1,000 
 667 $333. The dividend is equal to this $333 residual.

In this case, note that no additional stock is issued. Because the needed investment is

even lower in Rows 5 and 6, new debt is reduced further, retained earnings drop, and

dividends increase. Again, no additional stock is issued.

Given our discussion, we expect those firms with many investment opportunities to

pay a small percentage of their earnings as dividends and other firms with fewer oppor-

tunities to pay a high percentage of their earnings as dividends. This result appears to

occur in the real world. Young, fast-growing firms commonly employ a low payout ra-

tio, whereas older, slower-growing firms in more mature industries use a higher ratio.

Dividend Stability

The key point of the residual dividend approach is that dividends are paid only after all

profitable investment opportunities are exhausted. Of course, a strict residual approach

620 PART SIX Cost of Capital and Long-Term Financial Policy

FIGURE 18.3

Dividends ($)

1,000

667

333

0

–333

0

New investment ($)

500

This figure illustrates that a firm with many investment opportunities will pay small amounts

of dividends and a firm with few investment opportunities will pay relatively large amounts of

dividends.

1,000 1,500 2,000 2,500 3,000

Relationship Between Dividends and Investment in the Example of Residual Dividend

Policy