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CA Intermediate · Financial Management and Strategic Management · Dividend Decision

According to the residual theory of dividend policy, a firm should pay dividends only when:

Under the residual theory, dividends are paid only out of earnings left after financing all acceptable investment projects. Retained earnings are the first source of equity for such projects, so the dividend is the residual, and no dividend is paid when earnings are fully needed for investment.

  1. AIts earnings exceed the amount needed to finance acceptable investment projectsCorrect
  2. BIts share price is below the book value per share
  3. CIts shareholders demand a fixed payout every year
  4. DIts debt-equity ratio is above the industry average

Explanation

Under the residual theory, retained earnings are first used to fund all acceptable (positive NPV) investments. Only the leftover or residual earnings are distributed as dividends. Paying a fixed payout regardless of investment needs contradicts this approach.

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