According to the theory of dividend, the firm should follow its investment policy of accepting all positive NPV projects and paying out dividends if and only if funds are available:

Correct option is D

The Residual Theory of Dividends states that dividends should only be paid after the firm has funded all available and profitable investment opportunities. This theory is based on the premise that maximizing shareholders' wealth is the primary goal of a firm, and reinvesting earnings into positive NPV (Net Present Value) projects contributes to this objective.

Key Aspects of Residual Theory:

1. Profit Allocation Priority: Earnings are first allocated to fund profitable investments.
2. Dividend Distribution: Dividends are distributed only if there are surplus earnings after fulfilling investment needs.
3. NPV Projects: A project is considered profitable if it has a positive NPV, indicating its ability to increase shareholders' wealth.
4. Goal: The primary objective is to maximize shareholder value by balancing reinvestment and dividend payouts.

For example, if a firm earns ₹10 million in a year and has ₹7 million in profitable investment opportunities, the remaining ₹3 million would be distributed as dividends.

Information Booster

• Advantages of Residual Theory:
  • Promotes reinvestment in growth-oriented opportunities.
  • Aligns with the wealth maximization objective.
• Practical Challenges:
  • Dividend payouts may fluctuate significantly.
  • May not satisfy shareholders who rely on steady dividend income.

This approach is suitable for firms operating in industries with ample growth opportunities but may not be ideal for mature industries with limited reinvestment needs.

Additional Knowledge

(a) Bird-in-hand theory:
This theory, proposed by Myron Gordon and John Lintner, suggests that investors prefer certain and immediate dividends over uncertain future capital gains. Unlike the residual theory, it focuses on providing consistent dividends to reduce investor risk.

(b) Investor rationality theory:
This theory emphasizes that rational investors evaluate a firm's dividend and investment decisions based on the overall impact on shareholder wealth. It does not prioritize reinvestment over dividends.

(c) 100 percent retention theory:
According to this theory, the firms should retain all their earnings and reinvest them to maximize growth and shareholder value, with no dividend distribution. It is the opposite of dividend payout-focused theories like bird-in-hand.