Dividend policy

Concept

Company’s total net income (especially, earning available to equity shareholders) can be divided into two parts: earning to be distributed to the equity shareholders and earning to be kept in the organization. Earnings that are distributed the shareholders are known as dividend and earnings that kept in the organization are known as retained earnings. Dividend policy determines the division of earning between payments to stockholders and reinvestment in the firm. Therefore, the decision regarding how much profit to distribute to the shareholders and how much keep in the organization is the dividend policy. The dividend decision is guided by number factors and company always should consider these factors at the time of dividend decisions.

Factors affecting dividend decisions

Dividend policy is concerned with deciding the part of profit to be distributed to the shareholders. Such a policy depends on various factors, which, include the number investment opportunities available, availability of cash, repayment of debt, control, restrictive covenants, bond indentures, taxes, legal rules, cost of selling new stocks, nature of investors etc.

Investment opportunity

The available profitable investment opportunities of firm affect the dividend decision. If the company has lot of such opportunities, it needs excess fund to finance. So, the company retains more profit paying fewer amounts as dividend.

Liquidity

The liquidity position of the firm also affect to the fraction of profit to be distributed to the shareholders. Dividend payments represent cash outflows, the more liquid a firm is, and the more able it is to pay dividends. But a rapidly growing firm with many profitable investment opportunities fined it difficult to maintain adequate liquidity and pay fewer dividends at the time.

Earning stability

A company with stable earnings pays more dividends in a prospect of continuity of the earnings in the future. But a company having fluctuating earnings pays less dividends to face its future financial difficulties.

Growth prospects

A rapidly growing firm usually has a substantial need of funds to finance the abundance of attractive investment opportunities. Instead of paying large dividends and then attempting to sell new shares to raise the equity investment capital it need. This type of firm usually retains larger portions of its earnings and avoids the expenses and inconvenience of public stock offerings

Legal constraints

Legal provisions of the respective countries affect the dividend decisions of the firm. For example, a firm’s capital can not be used to make dividend payments, dividends must be paid out of a firm’s present and past net earnings, dividend can not be paid when the firm is insolvent, company can not borrow to pay dividend etc.

Restrictive covenants

Restrictive covenants contained in bond indentures, term loans, shot-term borrowing agreements, lease contracts and preferred stock agreements affect the dividend decision. These restrictions limit the total amount of dividends a firm can pay.

Control

The existing controlling group wanting to continue their position wants to retain more profit paying fewer dividends. If the company raises additional fund selling new common stock, the chances of diluting the control position will increase. Similarly, on the other sides, increasing loan amount also increase the risk of existing shareholders. Because of these, a company can retain more profit paying less as dividend.

Need to repay debt

If the company has to repay the debt in the current year, it needs more fund and retains more profit paying fewer amounts as dividend.

Shareholders preferences

In a closely held corporation with relatively few stockholders, management may be able to set dividends according to the preferences of its stockholders. For example, assume that the majority of a firm’s stockholders are in high marginal tax brackets. They probably favor a policy of high earnings retention, resulting in eventual price appreciation, over a high payout policy.

But in a large corporation whose shares are widely held, it is nearly impossible for a financial manager to take individual shareholders preferences into account when setting dividend policy.