The residual dividend theory is based on the observation that flotation costs make the cost of new common stock significantly higher than the cost of retained earnings.

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The residual dividend theory suggests that a company should fund its capital expenditures and dividends using retained earnings first, and then use external financing if needed. This is because the cost of issuing new common stock (external financing) is higher due to flotation costs such as underwriting fees, legal fees, and other expenses. Therefore, it is more cost-effective to use retained earnings for funding when possible.

The Residual Dividend Theory Is Based on the Observation That