What Is a Residual Dividend Policy?
A residual dividend policy is a means of calculating dividends that are based on the amount of equity that remains after capital expenditures associated with the investment have been met. The approach calls using the company’s cash flow to meet its current financial obligations, then issuing dividends to investors based on the residual, or what is left after those obligations are fulfilled. Most companies will use a specific formula to determine what percentage of the residual is utilized in calculating dividend payments.
One of the benefits of using a residual dividend policy is that the arrangement does tend to support the ongoing financial security of the business. This is important to investors who plan on holding onto the shares issued by the company over the long term. Since the company is paying its capital expenditures first, then moving on to determine the amount that will be paid out in dividends, the business is likely to remain stable, hold a steady credit rating, and in general be considered a good risk. This in turn means that the stock issued by the company is more likely to hold its value and possibly even incrementally appreciate.
For the business, using a residual dividend policy makes it easier to keep the operation going without having to engage in any type of creative accounting processes. Since the capital expenses are paid out of cash flow, there is less of a need to borrow in order to continue the basic operation. Depending on the strength of the cash flow, it may be possible to cover all relevant expenses, issue dividends using that remainder or residual after settling the capital expenditures for the current period, and even set aside funds to aid in future expansion projects. Companies of all sizes and types can make use of this approach to issuing dividend payments, since it does allow businesses to calculate the payments in a manner that is less likely to produce an adverse affect on the core operation.
The particulars of how dividends are calculated using a residual dividend policy will depend on how the company chooses to structure the process at the time the shares are issued. Typically, there are some differences based on the types of stock issued by the company, with preferred shareholders receiving dividends calculated using one method and other investors using a different method or percentage. One potential drawback of using a residual dividend policy is that if there is not much left in the way of residuals after the capital expenditures are settled, this will mean fewer dividends for the stockholders.
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