Video Transcript: The Residual Distribution Model

Hello, welcome. We're going to discuss the residual distribution model when  deciding how much cash to distribute to stockholders, two points should be kept  in mind. The overriding objective is to maximize shareholder value, the firm's  cash flows really belong to its shareholders. So a company should not retain  income unless managers can reinvest that income to produce returns higher  than shareholders could themselves earn by investing the cash in investments  of equal risk. On the other hand, keep in mind that internal equity reinvested  earnings is cheaper than external equity new common share issuances because it avoids flotation costs and adverse signals. So if we issue new stock, we've got to pay most the time an investment bank to take that share issuance to market.  Those are known as flotation costs. And if we're issuing new stock, it may signal  to the market, hey, we're having financial troubles because we are having a new equity raising. This encourages firms to retain earnings so as to avoid having to  issue new stock. So retain the earnings right, we need to use the earnings to  fund the operations instead of paying out the max dividend. Shareholders may  be okay with that, because that's better than the company going out into the  market and signaling financial distress by issuing new stock so shareholders  may take less dividend for a quarter or two to help get cash positions more  stable when establishing a distribution policy. One size did not does not fit all.  Some firms produce a lot of cash but have limited investment opportunities. This is true for firms and profitable but mature industries in which few opportunities  for growth exist. Such firms typically distribute a large percentage of their cash  to shareholders, thereby attracting investors that prefer higher dividends. Other  firms generate little or no excess cash because they have many good  investment opportunities. Such firms generally don't distribute much cash, but  do enjoy rising earnings and stock prices, thereby attracting investors who  prefer capital gains. So you're going to look here that there are going to be two  types of investors, of investors in equities, one an investor that enjoys higher  dividend payments, so companies can keep a higher dividend, not too high of a  dividend, but a higher dividend. Potentially the market, let's say, instead of three  and a half percent, they're issuing a dividend at five, which will attract high  dividend yield investors. Now, some companies may withhold their dividend  issuances in and reinvest that money back into the operation, creating  opportunities for growth of revenue and profit growth, which will drive the stock  price higher, creating capital gains. So investors are either investing in dividends of the company, or they're investing for the potential capital gains. Capital Gain,  remember, is the appreciation of stock price, so if it goes from 10 to 15, it's a $5  capital gain. Dividend payouts and dividend yields for large corporations vary  considerably. Generally, firms in stable cash producing industries such as  utilities or financial services pay relatively high dividends, whereas companies in rapidly growing industries such as computer software tend to pay lower  dividends. So utilities and financial services, they're not making a whole lot of 

reinvestment choices. So they're going to be cash flush or have a high cash  position in most cases, so therefore they'll be willing to pay the free cash flow  out to shareholders through forms of dividends. But if you see in these growing  industries like computer software, they pay lower dividends because their  industry is always changing, always evolving, and they need to stay up with their research and development of new products, and so they can innovate and stay  ahead of the market or compete in the market. So instead of paying that out into a dividend, they'll take that money, retain it as earnings, and reinvested into the  company so that we continue to grow our operations, this will fuel the  appreciation of stock price, creating a capital gains opportunity for a given firm.  The optimal distribution ratio is a function of four factors, one, investors,  preferences for dividend. Ins versus capital gains, the firm's investment  opportunities, its target capital structure, the availability and cost of external  capital. The last three elements are combined in what we call the residual  distribution model. Under this model, a firm follows these four steps when  establishing its target distribution ratio, it determines the optimal capital budget.  It determines the amount of equity needed to finance that budget. Given its  target capital structure, it uses reinvested earnings to meet equity requirements  to the extent possible. And number four, it pays dividends or repurchases stock  only if more earnings are available than are needed to support the optimal  capital budget. So in our optimal capital budget, we need to make sure that we  have all the cash that we need factored in to run the operations at an optimal  level. The word residual implies left over, and the residual policy implies that  distributions are paid out of leftover earnings. So anything that we don't need, as far as free cash flow to reinvest into our company, then we can pay out  distributions through residual earnings. If a firm rigidly follows the residual  distribution policy, then distributions paid in any given year can be expressed as  follows. So we'll see that distribution equals net income minus retained earnings  needed to finance new investments. How do we know what return retained  earnings needed to finance investments would be? So we'll have a target equity  ratio, and we'll multiply that by our total capital budget. So we'll have a debt  ratio, and we'll have an equity ratio. Let's say we're funded 60% equity, 40%  debt, right? Then we'll multiply that 60% figure by the total capital budget, then  we'll subtract that out of net income to get our distribution so consider the case  of Texas and Western transport company, which has 60 million in net income  and a target capital structure of 60% equity and 40% debt. If T&W forecasts  poor investment opportunities, then its estimated capital budget will only be 40  million to maintain the target capital structure, 40% or 16 million of this capital  must be raised as debt, and 60% 24 million must be equity, if it is followed at the strict residual policy is followed T & W would retain 24 million of its 16 million  earnings to help finance new investments and then distribute the remaining 36  million to shareholders. So you'll see, how do we how do we get this right? So if 

we maintain our target capital structure, we will have 60 million in earnings or in  net income. Now we'll see that our target equity ratio is 60% and our total capital budget is 40 million. So we will take the 60 in net income and we'll subtract out  the 24 million from the target equity ratio, multiplied by the total capital, which is  

gives us 24 million. So the 60 million net income will have subtracted out 24  million. So the 36 million that's left over now we have that available for  distribution. So we have to make sure that the 60% raised as debt, 60% is paid  out right, is retained as earnings. Then we can use the rest of the distribution,  the 36 million, to pay out shareholders and debt payments. In contrast, if the  company's investment opportunities are average, its optimal capital budget  would rise to 70 million. Here it would require 42 million of retained earnings. So  distributions would be 60 million, minus 42 million is 18 million, for a ratio of 30% or 18 over 60 finally, if investment opportunities are good, then the capital  budget would be 150 million, which would require .6 of the 100 and 50 million.  So 60% of the 100 50 million would be 90 million. In an equity, and this case, T  & W would retain all of its net income, 60 million and thus make no distributions  because the required equity exceeds the retained earnings. The company would have to issue some new common shares to maintain the capital target structure. So you can see in the investment opportunities column. So if we have good  investment opportunities, our capital budgets 150 million, our net income is 60  million, but our required equity is 90. So we only have net income of 60 million,  but our required equity is 90, so we're going have to raise more capital through  the issuance of equity to meet that 90 million required equity figure. So we only  have 60 million net income with $30 million short we need to issue new equity to the market to make do and to close that gap, the $30 million that we are under  capitalized in the equity market, so we need to go to the equity market. We need to issue the stock and raise the additional 30 million to meet our required equity  ratio, because investment opportunities and earnings will surely vary from year  to year. A strict adherence to the residual distribution policy would result in  unstable distributions. One year, the firm might make no distributions because it  needs the money to finance good investment opportunities. But the next year,  might make a large distribution because investment opportunities are poor and  so it does not need to retain much capital. Similar similarly fluctuating earnings  could also lead to variable distributions, even if investment opportunities were  stable.