If a firm adheres strictly to the residual dividend policy, and if its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio), then the firm should pay
A) the same dividend as it paid the prior year.
B) no dividends to common stockholders.
C) dividends only out of funds raised by the sale of new common stock.
D) dividends only out of funds raised by borrowing money (i.e., issuing debt).
E) dividends only out of funds raised by selling off fixed assets.

Question

Quizplus · Accepted Answer

The residual dividend policy states that a firm should first use all of its earnings to finance its optimal capital budget, which includes new debt according to the target debt/total assets ratio. If after financing the optimal capital budget there are any remaining earnings, then these can be paid out as dividends. However, if the optimal capital budget requires the use of all earnings, then there will be no funds available for dividend payments. Therefore, the firm should not pay any dividends to common stockholders in this scenario (i.e. choice B is correct).

If a Firm Adheres Strictly to the Residual Dividend Policy