The capital market is a complicated synergy of many moving parts, and one entity has a big role in all of it: investors. Companies typically acquire investors to get funding for a business, but investors only invest if they can have something attractive in return. For many investors, dividends are appealing because they can become another regular income stream.
What is a dividend?
A dividend is simply a portion of the profits a company makes that’s paid out to investors and/or shareholders. There are many different ways shareholders can receive dividends. They can receive more stock, or they can also receive cash payments. Most companies will pay out dividends each quarter, but all of those details get ironed out under a dividend policy. A company’s Board of Directors decides upon the dividend policy—how much and how often shareholders will receive dividends.
What is a residual dividend policy?
A residual dividend policy is basically one type of dividend policy, which states that a company will prioritize capital expenditures before paying out dividends to shareholders. Anytime a company follows the model of a residual dividend policy, it doesn’t have an excess cash at any given time. All cash is distributed to pay for the operational needs of the business (reinvestment). Any excesses are then paid out to shareholders. Any business in operation has expenses, and companies must know these numbers in order to propose a proper dividend policy agreement with investors. Given the nature of residual dividend policies, they often attract a specific kind of investors—ones that are indifferent to the amount or type of dividends they might receive. Under this type of dividend policy, shareholders can’t expect uniform and consistent investments. It may seem counterintuitive, but shareholders invest their money for various reasons and often because they see some type of capital gain later on.
A residual dividend policy allows a business to focus on development and growth. It’s a more secure policy that focuses on long-term stability rather than immediate but profitability. This model allows a company to have a simpler form of accounting because basic operational expenses are paid out of cash flow. It eliminates the need to borrow funds in order to cover relevant expenses, especially if the cash flow is steady and strong. A company might opt to have a residual dividend policy to issue dividends payments because it protects the core operation of the business.
What about smooth dividend policy?
A smooth dividend policy prioritizes dividend payments towards shareholders rather than the business itself. Although this might be initially attractive for investors, it can cause an adverse effect for a business if profits are low. If that’s the case, a business will have to finance dividends or capital expenditures or both just to keep the company in good standing. Because of this, a residual dividend policy is oftentimes regarded as more efficient in comparison. It ensures that cash flow is always distributed for profit first.
Residual dividend model
In a residual dividend policy model, dividend amounts tend to follow the curvature of a company’s net income. A company might pay out dividends in the amount of $50 million one year and it might pay out $150 million the next year—with expenditures taken care of and no need for extra funding. In a smooth residual model, the dividend amount will stay in a straight line regardless of how much the net income fluctuates—whether profits are high or low. If a shareholder is contracted to get $100 million in dividend payments each year, he will get this amount whether the company makes $200 million or $50 million. The deficits will have to be covered through another investment or a short-term bank loan.
Advantages and disadvantages
Having a residual dividend policy has a lot of advantages for a company. Business owners always have to balance the needs of a company and the needs of shareholders, but a profitable business is good for both entities. Every company requires assets, and maintaining assets and operating businesses always require expenses. Although regular and average expenditures can be predicted, there are always variables in business that are out of control. Having a residual dividend policy model allows a business some flexibility and responsiveness.
This kind of model also ensures the financial stability of a company on the long-term. Investors coming into a project that follows a residual dividend policy know exactly what they’re getting into—unpredictable dividends. This policy attracts investors and shareholders that are in it for the long-term. These are investors that plan to hold onto their shares as long as it takes to see profit. Most of the time, investors invest because they see large profits somewhere down the line. Since a business will focus on reinvesting cash into improving a business first, it becomes more likely for the business to remain stable over time. Without excesses of funding, credit ratings will also remain in good standing. If the business remains balanced and successful, the initial stock values should hold over time and maybe even appreciate later on.
The disadvantage of having a residual dividend policy falls mostly on the shareholders. Residual dividend policies tend to be a riskier pursuit for investors because dividends or capital gains are not guaranteed. An investor has to be willing to take on this risk if he or she is willing to take on an investment that uses a residual dividend policy. For business, the disadvantage of this kind of policy comes with constantly having to justify dividend payouts and fluctuations to shareholders. While this may not be an issue for some, it can become problematic if the fluctuations are excessive. Shareholders like to see stability in a company; and if they are already investing in a riskier policy, too many fluctuations might seem like too much of a liability to stay on.