What does the residual theory of dividend policy state?

• A. Dividends are designed to come from earnings and are always fixed
• B. Dividends are determined solely by managerial preferences
• C. Dividends are determined by earnings minus retained earnings needed to fund positive-NPV projects; dividends come from residuals
• D. Dividends should never be paid even if there are positive-NPV projects

Answer: (C)

The residual theory treats dividends as the leftover cash after a company has funded all attractive investment opportunities. Firms first retain earnings to finance positive-NPV projects, and the portion of earnings that remains after those funding needs is paid out as dividends to shareholders. Because investment opportunities and the amount of capital needed can vary with earnings and project opportunities, dividend payments under this approach are not fixed but fluctuate with the firm's investment needs. If there are no positive-NPV projects to fund, the firm can distribute all earnings as dividends. This matches the idea that dividends come from earnings minus the retained earnings required for positive-NPV investments, i.e., the residuals. The other views—having fixed dividends, basing dividends solely on managerial preferences, or never paying dividends even when there are good projects—do not reflect this funding-first, remainder-as-dividends approach.