An Example: The Residual Dividend Model

[Pages:3]WEB APPENDIX 14A

An Example: The Residual Dividend Model

In the chapter we discussed the problem with strict adherence to the dividend residual model. In practice, companies use the residual dividend model to develop an understanding of the determinants of an optimal dividend policy, but they typically use a computerized financial forecasting model when setting the target payout ratio. Most larger corporations forecast financial statements over some horizon (usually 5 to 10 years). Projected capital expenditures and working capital requirements are entered into the model, along with sales forecasts, profit margins, 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 firm's target capital structure. From all these data, the funds available for shareholder distribution can be determined. Table 14A-1 illustrates how Langdon Trading Inc. combines the forecasting model and the residual dividend model to determine its

TA B L E 1 4 A - 1 Long-Run Residual Dividend Model Forecast

14A-1

14A-2 Web Appendix 14A An Example: The Residual Dividend Model

payout policy. This spreadsheet is provided in the model developed for this chapter--just click on the tab labeled Web Appendix 14A.

Langdon's analysts have made the assumptions shown and estimated the firm's expected earnings and required assets over the next five years. In Langdon's case, the required new investment represents the capital the firm must invest to fund its future capital budget. The firm expects its assets, in general, to grow at 12 percent, which its initial forecast reflected. In a subsequent forecast, Langdon recognized a very large expenditure needed in the third year so it added this investment ($200 million) to the Year 3 total assets. Hence, the investment in Year 3 is far greater than the other years.

Applying the residual dividend model across the forecast period, Langdon is expected to have $862 million available for distribution to shareholders. As a result, Langdon sets the initial dividend at 80 percent of the average available funds per year, which allows Langdon to steadily increase its dividend each year by 8 percent. If Langdon's forecasts play out, the firm will be able to grow its dividend at 8 percent per year and after five years it will have paid $809 million, which means there will be excess funds left. If earnings are not quite as good or investment opportunities are more abundant, Langdon will have some slack to help meet funding requirements. Figure 14A-1 shows the relationship between the firm's earnings, funds available for distribution, and expected dividends paid.

The year-by-year dividend payout ratio seems to be going down, but this just reflects a steady dividend relative to faster growing earnings. The dividend payout ratios are consistent with a long-run target payout ratio of 50 percent. However, it is important to note that these projections are not set in stone. Each year, Langdon revisits the dividend question by updating its forecasts and considering any excess funds (or shortfalls) from previous years. Like many companies, Langdon treats the dividend decision as an ongoing process. To make its analysis more complete, Langdon also considers the effect of varying investment

F I G U R E 1 4 A - 1 Langdon Trading Dividend Payout Policy

Millions of dollars

500

400

300

Earnings Funds available

200

100

0

1

2

Dividends paid

3

4

5

Years

Web Appendix 14A An Example: The Residual Dividend Model 14A-3

opportunities on the funds it has for distribution. If poor investment opportunities existed (assets growing by only 9 percent), the firm would have an average dividend payout of nearly 63 percent, while strong opportunities (assets growing at 15 percent) would result in a payout of about 36 percent.

Also, note that Figure 14A-1 highlights a key point from the chapter, which is that strict adherence to the residual dividend model would have resulted in a wildly fluctuating dividend over the five years. However, using a forecasting model to apply the residual model over a five-year horizon results in a smoother, more predictable dividend for investors.

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