The Advantages of the Residual Theory of Dividends
One of the primary problems of corporate finance is to determine what to do with earnings.
The basic issue is to decide how much to re-invest in the business for future growth and how much to return directly to shareholders in the form of dividends.
The residual theory of dividends states that a firm's retained earnings should be used first to make all available investments to increase long-term earnings. Only residual earnings remaining after all such investments are made should be used to pay dividends to shareholders.
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About the Theory
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The residual theory of dividends requires exploring all investment opportunities available to a firm. They should be compared to the firm's marginal costs. If the expected return on an investment is greater than the marginal costs, then the investment should be made. This analysis is applied to all potential investments.
Advantages to Company
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Using the residual theory of dividends produces superior long-term earnings growth when compared to other methods. This is because its use devotes all of a firm's available resources to long-term investments. Dividends are not efficient from the firm's point of view because it is "lost capital" that could have been used to increase the firm's future growth.
As long as the firm's expected return on investments is greater than its cost of capital, according to corporate financial theory, an investment would produce positive growth and should be made. If enough acceptable investment opportunities exist, then the company should borrow or increase equity to raise funds to make as many of the investments as possible. In this case, no dividends would be paid.
Because this policy would improve long-term growth, ultimately it would increase the net present value of future cash flows and increase the firm's value.
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Advantages to Shareholders
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Only when the firm does not have remaining positive investment alternatives should it pay dividends to shareholders. This aspect should benefit shareholders because it produces long-term growth in the firm's shares' value, resulting in the best long-term profit for shareholders. This aspect also is optimal for shareholders from a tax standpoint because dividends are taxed as short-term income, and long-term stock gains are taxed at the lower capital gains rate.
Although dividends are short-term income to the shareholders, funds that can be used to generate a superior rate of return to the company maximize shareholders' wealth if reinvested rather than paid as dividends.
Message to Wall Street
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Another benefit of this policy is that it signals potential shareholders that the company is motivated by maximizing long-term profits and will not be driven by short-term results. It is a signal to the investment community that the company is a "growth company" rather than an "income company." This strategy is very positive to potential investors seeking long-term gains.
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References
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