What does the residual theory of dividends suggest?

The residual theory of dividends posits that a company should pay dividends only after it has funded all profitable investment opportunities. According to this theory, dividends are considered a residual amount left over after the company has met its capital expenditures for worthwhile projects.

Under this approach, the priority is given to reinvesting profits into projects that can generate a return on investment greater than the company’s cost of capital. Once these investments are satisfied, any remaining earnings can then be distributed to shareholders as dividends. This theory aligns with the idea that the primary objective of a firm is to maximize shareholder wealth through reinvestment rather than through immediate distribution of profits.

The other options, while they reflect different dividend policies or beliefs, do not capture the essence of the residual theory. For instance, the suggestion that dividends should be paid regardless of profits contradicts the core of the residual theory, as it implies that companies can distribute money even when it would be unwise to do so due to lack of profitable investments. Similarly, the idea of dividends being the first expense to be allocated disregards the investment opportunities the company has, while stating that dividends should always increase annually does not take into account the company’s investment needs and profit levels.