Final answer:
The residual dividend model means that investors should expect variable dividends based on a company's residual profits after operational and reinvestment needs. This approach leads to uncertainty in dividend amounts, as they can increase or decrease with the company's performance and investment decisions.
Step-by-step explanation:
The residual dividend model is a policy used by companies to determine the amount of dividends they will pay out to shareholders. In this model, dividends are not fixed and can fluctuate because they are based on the residual profits of the company after all operating expenses and reinvestment needs are met. This means that investors should expect a level of uncertainty regarding their dividends, as the amounts distributed can vary depending on the company's earnings and investment opportunities.
For example, consider a company with a residual dividend policy that determines to reinvest a certain percentage of its earnings back into the company for growth and only pays out what is left as dividends. If the company has a profitable year with fewer investment needs, shareholders may receive higher dividends. However, if the company's earnings are lower or it decides to invest more in expansion, dividends may decrease or not be issued at all.
To mitigate the uncertainty of the residual dividend model, shareholders often engage in diversification investing, placing their money in a wide range of companies to reduce risk. It's also important to note that the expectation of dividends can differ from the pattern of a company's net income, which gives rise to the varying yields observed in historical data of the S&P 500 index.