This theory is based on the assumption that either he eternal financing is not available to the firm or if available, cannot be used due to its excessive costs of financing the profitable investment opportunities of the firm. Therefore, the firm finances its investments decisions by retaining profits. The quantum of profits to be distributed is a balancing figure and thus depends upon what portions of profits to be retained. If a firm has sufficient profitable investment opportunities, then the wealth of the shareholders will be maximised by retaining profits and reinvesting them in the financing of investment opportunities either by reducing dividend or even by paying no dividend to the shareholder. If a firm has no such investment opportunity, then the profits may be distributes among the shareholders.
Thus firm does not decide how much dividends to be paid rather it decide as to how much profits should be retained. The dividends are a distribution of residual profits after retaining sufficient profit for financing the available opportunities. This is referred to as Residuals Theory of Dividends.
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