ACCA Advanced Financial Management (AFM) Practice Exam

What is a notable disadvantage of the residual payout policy?

1. It results in fixed dividends

2. It leads to variable dividends and conflicting signals

3. It maximizes company earnings

4. It enhances corporate governance

The correct answer is: It leads to variable dividends and conflicting signals

The notable disadvantage of the residual payout policy is that it leads to variable dividends and conflicting signals. A residual payout policy dictates that dividends are paid only after all profitable investment opportunities have been exhausted. This means that the amount paid out as dividends can fluctuate significantly from period to period based on the availability of profitable projects. Because the dividends may vary widely, this creates a lack of predictability for shareholders. Such variability can cause confusion and uncertainty among investors, who may interpret decreasing dividends negatively, even if the company is reinvesting in growth opportunities that could enhance future earnings. This conflicting signal can undermine investor confidence and lead to volatility in the company's stock price, as investors grapple with the implications of changing dividend levels. In contrast to other options, a residual payout policy does not guarantee fixed dividends or maximize company earnings directly. It also does not inherently enhance corporate governance but rather focuses on the careful allocation of capital based on investment opportunities.