What is Dividend Policy?
Once a company makes a profit, management must decide on what to do with those profits. The management could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. The part of the profit that is distributed is termed as dividend.
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The ratio of the actual distribution or dividend, and the total distributable profits, is called dividend payout ratio. Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets.
The decision about management of profit depends on the current and future situation of the company. It also depends on the preferences of investors and potential investors.
Objectives of Dividend Policy
A finance manager may treat the dividend decision in the following two ways:
- As a long term financing decision- When dividend is treated as a source of finance, the firm will pay dividend only when it does not have profitable investment opportunities. On the other hand, the firm can also pay dividend and raise an equal amount by the issue of shares but this does not make any sense.
- As a wealth maximisation decision- Payment of current dividend has a positive impact on the share price. So, in order to maximise share price, the firm must pay more and more dividends.
Factors Affecting Dividend Policy
- Dividend payout ratio: It refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm.
The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm’s shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm’s owners and providing sufficient funds to finance growth. These objectives are interrelated.
- Stability of dividends: Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:
- a. Constant dividend per share: A company may follow a policy of paying a certain fixed amount per share as dividend. For example, on a share of face value of Rs 200, firm may pay a fixed amount say Rs 10 as dividend. This will be paid year after year irrespective of level of earnings.
- Constant dividend payout ratio: Under this policy a firm pays a constant percentage of net earnings as dividend to the shareholders. In each dividend period.
- Constant dividend per share plus extra dividend: Using this policy, a firm usually pay affixed dividend to the shareholders and in a year of good performance, an additional or extra dividend is paid over and above the regular dividend.
- Legal, contractual and internal constraints and restrictions: Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds.
These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, and financial requirements, availability of funds, earnings stability and control.
- Owner’s considerations: The dividend policy is also likely to be affected by the owner’s considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership. This is an external factor as companies cannot control what investors want or expect from their industry.
- Capital market considerations: The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
- Inflation: With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipment and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.