Dividend as a residual payment & corporate dividend behavior


Internal equity (in the form of retained earnings) is cheaper than external equity. An important dividend prescription advocates a residual policy to dividends. According to this policy the equity earnings of the firm are first applied to provide equity finance required for supporting investments. The surplus, if any, left meeting the equity investment needs is distributed as dividends. Put differently, dividends are merely treated as a residual payment after equity investment needs are fulfilled.

Firms subscribing to the residual dividend policy may adopt one of the following approaches:

Pure Residual Dividend Approach:

According to this approach, dividends are equal to earnings minus investment needs. Obviously when investment exceed earnings no dividends are paid.

Fixed Dividend Payout Approach:

As per this approach, dividends are a fixed proportion of earnings. The proportion is set in such a manner that in the long run dividends are equal to equity earnings minus equity finance required to support investments.

Smoothed Residual Dividend Approach:

Under this approach, dividends are varied gradually over time. The level of dividends is so set that in the long run the total dividends paid are equal to total earnings less equity finance required to support investments.

The pure residual approach tends to produce highly fluctuating dividends because the variability of equity earnings and investment budget (given a certain debt-equity ratio) is transmitted to dividends. When the fluctuations in equity earnings and investments budget are identical in nature, dividends are stabilized. This is a very rare possibility. Likewise the fixed dividend payout ratio generates a fluctuating dividend stream because the variability of earnings is transmitted to dividends.

Since investors are generally averse to fluctuating dividends for various reasons, the pure residual dividend approach and the fixed dividend payout ratio approach are often not advisable in practice. The smoothed residual dividend approach, which produces a stable and steadily growing stream of dividends, often appears to be the most sensible approach in practice.

* Most of the firms think primarily in terms of the proportion of earnings that should be paid out as dividends rather than in terms of the proportion of earnings that should be ploughed back in the firm.

* Firms try to reach the target payout ratio gradually over a period of time because stockholders prefer a steady progression in dividends.

Linter an eminent economist expressed corporate dividend behavior in the form of the following model:

Dt= cr EPSt + (1-c)Dt-1——-Equation 1

Dt= dividend per share for year t
c= adjustment rate.
r= target payout rate.
EPSt= earnings per share for year t
Dt-1= dividend per share for year t-1


Kinematics Ltd has earnings per share of Rs. 4.00 for year t. Its dividend per share for year t-1 was Rs. 1.50. Assume that the target payout ratio and the adjustment rate for this firm are 0.6 and 0.5 respectively. What would be the dividend per share for kinematics Ltd for year t if the Linter model applies to it?

Kinematics’ dividend per share for year t would be:

0.5 x 0.6 x Rs.4.00+0.5 x Rs.1.5 = 1.95.

The Linter model shows that the current dividend depends partly on current earnings and partly on previous year’s dividend. Likewise the dividend for the previous year depends on the earnings of that year and the year and the year preceding that year so on and so forth. Thus, as per the Linter model, dividends can be described in terms of weighted average of past earnings.

From Equation 1 we may obtain the following equation which seeks to explain the change in dividend from year t-1 to year t.

Dt–Dt-1=c(rEPSt-1–Dt-1)——–Equation 2.

The change in dividend, Dt – Dt-1 is equal to the product of the adjustment factor ‘c’ and the difference between the target dividend, rEPSt and the previous dividend, Dt-1. The adjustment factor ‘c’ is small when the firm is very conservative and large when the firm is very aggressive.