Residual Theory of Dividend

How much dividend a company should distribute will depend on how much investment opportunities it has available at present. If there are positive NPV projects available then instead paying dividends to shareholders the same can be used in financing the positive projects. In the case shareholders wealth maximized by reducing dividend at all.  Shareholders will be compensated for this reduction on nill dividend now by a gain in the form of higher dividend in the future.

Dividends are thus residual payment in the sense that this is paid provide sufficient earnings are retained in the company to finance new investments. This residual theory treats dividend as a passive decision which is completely depended on how much amount or whether company employs earnings is in financing profitable projects. Thus the dividend will vary from year to year. But such fluctuations in dividend have no effect on shareholders as they are compensated of present loss, if any of dividend by future capital gain”(Waring, 1983).