Reading: The Residual Distribution Model
The
Residual Distribution Model
•When
deciding how much cash to distribute to stockholders, two points should be kept
in mind:
(1) The overriding objective is to maximize shareholder value
(2) 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.
(1) The overriding objective is to maximize shareholder value
(2) 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 stock
issues) because it avoids flotation costs and adverse signals. This encourages
firms to retain earnings so as to avoid having to issue new stock.
•When
establishing a distribution policy, one size does not fit all. Some firms
produce a lot of cash but have limited investment opportunities—this is true
for firms in 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 high 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.
•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.
•For a
given firm, the optimal distribution ratio is a function of four factors:
(1) investors’ preferences for dividends versus capital gains
(2) the firm’s investment opportunities
(3) its target capital structure
(4) the availability and cost of external capital. The last three elements are combined in what we call the residual distribution model.
(1) investors’ preferences for dividends versus capital gains
(2) the firm’s investment opportunities
(3) its target capital structure
(4) 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:
(1) it determines the optimal capital budget
(2) it determines the amount of equity needed to finance that budget, given its target capital structure
(3) it uses reinvested earnings to meet equity requirements to the extent possible
(1) it determines the optimal capital budget
(2) it determines the amount of equity needed to finance that budget, given its target capital structure
(3) it uses reinvested earnings to meet equity requirements to the extent possible
•(4)
it pays dividends or repurchases stock only if more earnings are available than
are needed to support the optimal capital budget.
•The
word residual implies “leftover,” and the residual policy implies that
distributions are paid out of “leftover” earnings.
•If
a firm rigidly follows the residual distribution policy, then distributions
paid in any given year can be expressed as follows:
•Consider
the
case of Texas and Western (T&W) 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 be only $40 million. To maintain the target capital structure, 40%
($16 million) of this capital must be raised as debt and 60% ($24 million) must
be equity. If it followed a strict residual policy, T&W would retain $24
million of its $60 million earnings to help finance new investments and then
distribute the remaining $36 million to shareholders:
最后修改: 2018年08月14日 星期二 08:54