Answer (D) is correct . The residual theory of dividends holds that the amount (residual) of earnings paid as dividends depends on the available investment opportunities and the debt-equity ratio at which cost of capital is minimized. The rational investor should prefer reinvestment of retained earnings when the return exceeds what the investor could earn on investments of equal risk. However, the firm may prefer to pay dividends when investment opportunities are poor and the use of internal equity financing would move the firm away from its ideal capital structure.
Answer (A) is incorrect because The residual theory of dividends does not hold that dividends are necessary to maintain the price of the stock.
Answer (B) is incorrect because The residual theory of dividends does not hold that dividends are irrelevant.
Answer (C) is incorrect because The residual theory of dividends does not hold that dividends can be forgone unless there is an excess demand for cash dividends.
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