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It is sometimes suggested that firms should follow a residual dividend policy. With such a...

Question:

It is sometimes suggested that firms should follow a residual dividend policy. With such a policy, the main idea is that a firm should focus on meeting its investment needs and maintaining its desired debt-equity ratio. Having done so, any leftover, or residual, income is paid out as dividends. What would be the chief drawback to a residual dividend policy?

Residual Dividend Policy:

Residual dividend policy is a dividend payout policy where an entity distributes the dividend to its shareholders out of the earnings of the company left after setting aside the funds for the anticipated capital expenditures of the current accounting period.

Answer and Explanation:

The major drawbacks of following the residual dividend policy are as follows:

  • Dividends vary with the availability of investment opportunities making dividend rate highly volatile.
  • The risk of the investors increases due to the volatility and they will demand higher dividends to compensate the high level of risk.
  • The stock with volatile dividends does not attract the investors who are risk averse or who wants moderate risk bearing securities.
  • The higher volatility results in the lower valuation of the stock.

Learn more about this topic:

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Dividend: Definition & Overview

from GMAT Prep: Tutoring Solution

Chapter 1 / Lesson 8
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