The residual dividend policy is a policy that when an enterprise has good investment opportunities, it calculates the difference between the necessary equity capital and the existing equity capital according to the target capital structure, firstly, the after-tax profits meet the needs of equity capital, and then the remaining part is distributed as dividends . . The residual dividend policy is conducive to maintaining the target capital structure of the enterprise.
The theoretical basis of the residual dividend policy is the MM theory of dividend irrelevance. This theory was first proposed by American financial experts Miller and Modigliani in their famous paper “Dividend Policy, Growth and Stock Value” in 1961, so it is called MM theory. Residual dividend policy generally applies to the start-up stage of the company.
Pros and cons of residual dividend policy:
Advantages: Retained earnings give priority to ensuring the need for reinvestment, thereby helping to reduce the capital cost of reinvestment, maintain the optimal capital structure, and maximize the long-term value of the enterprise.
Disadvantage: If the residual dividend policy is fully followed, the dividend payout will fluctuate from year to year with fluctuations in investment opportunities and profitability. Even if the profit level remains unchanged, the dividend will change in the opposite direction to the number of investment opportunities: the more investment opportunities, the less dividends; on the contrary, the fewer investment opportunities, the more dividends. In the case that investment opportunities remain unchanged, the amount of dividend distribution will fluctuate in the same direction due to the fluctuation of the company’s annual earnings. Residual dividend policy is not conducive to investors arranging income and expenses, and it is not conducive to the establishment of a good image of the company.