Answer (D) is correct . Under the residual theory of dividends, the residual of earnings paid as dividends depends on the available investments 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 returns are poor and the internal equity financing would move the firm away from its ideal capital structure. If Residco wants to maintain its current structure, 60% of investments should be financed from equity. Hence, it needs $720,000 ($1,200,000 × 60%) of equity funds, leaving $80,000 of net income ($800,000 net income – $720,000) available for dividends. The dividend payout ratio is therefore 10% ($80,000 ÷ $800,000 net income).
Answer (A) is incorrect because The reinvestment ratio is 90%.
Answer (B) is incorrect because The ratio between earnings and investment is 66.7%.
Answer (C) is incorrect because The ratio of debt in the ideal capital structure is 40.0%.
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