CP

Establishing the Dividend Policy in Practice 521

would retain all of its net income ($60 million), thus pay no dividends. Moreover,

since the required equity exceeds the retained earnings, the company would have to is-

sue some new common stock to maintain the target capital structure.

Since both investment opportunities and earnings will surely vary from year to

year, strict adherence to the residual dividend policy would result in unstable divi-

dends. One year the firm might pay zero dividends because it needed the money to

finance good investment opportunities, but the next year it might pay a large dividend

because investment opportunities were poor and it therefore did not need to retain

much. Similarly, fluctuating earnings could also lead to variable dividends, even if in-

vestment opportunities were stable. Therefore, following the residual dividend policy

rigidly would lead to fluctuating, unstable dividends. Since investors desire stable, de-

pendable dividends, rswould be high, and the stock price low, if the firm followed the

residual model in a strict sense rather than attempting to stabilize its dividends over

time. Therefore, firms should:

1. Estimate earnings and investment opportunities, on average, over the next five or
   so years.


2. Use this forecasted information to find the average residual model payout ratio and
   dollars of dividends during the planning period.


3. Then set a target payout ratiobased on the average projected data.
   Thus, firms should use the residual policy to help set their long-run target payout ratios, but
   not as a guide to the payout in any one year.
   Companiesusetheresidualdividendmodelasdiscussedabovetohelpunderstand
   the determinants of an optimal dividend policy, along with computerized financial
   forecasting models. Most larger corporations forecast their financial statements over
   the next five to ten years. Information on projected capital expenditures and working
   capital requirements is entered into the model, along with sales forecasts, profit mar-
   gins, depreciation, and the other elements required to forecast cash flows. The target
   capital structure is also specified, and the model shows the amount of debt and equity
   that will be required to meet the capital budgeting requirements while maintaining
   the target capital structure. Then, dividend payments are introduced. Naturally, the
   higher the payout ratio, the greater the required external equity. Most companies use
   themodeltofindadividendpatternovertheforecastperiod(generallyfiveyears)that
   will provide sufficient equity to support the capital budget without forcing it to sell
   new common stock or move the capital structure ratios outside the optimal range.
   Some companies set a very low “regular” dividend and then supplement it with an
   “extra” dividend when times are good. General Motors, Ford, and other auto companies

TABLE 14-2 T&W’s Dividend Payout Ratio with $60 Million of Net Income

When Faced with Different Investment Opportunities

(Dollars in Millions)

Investment Opportunities

Poor Average Good

Capital budget $40 $70 $150

Net income $60 $60 $ 60

Required equity (0.6 Capital budget) 24 42 90

Dividends paid (NI Required equity) $36 $18 $30a

Dividend payout ratio (Dividend/NI) 60% 30% 0%

aWith a $150 million capital budget, T&W would retain all of its earnings and also issue $30 million of new stock.

Distributions to Shareholders: Dividends and Repurchases 517