A firm’s dividend policy may treat dividends either as the residual part of a financing decision or as an active policy strategy.

Treating dividends as the residual part of a financing decision assumes that

Answer (A) is correct. According to the residual theory of dividends, 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.