CORPORATE DIVIDEND PRACTICE
One consideration is the desire to have a relatively stable dividend; the second is the desire to pay out, in the long run, a given fraction of earnings. This fraction is usually referred to as the payout target. These objectives may be conflicting. Earnings tend to fluctuate substantially from year to year. If a corporation routinely paid out a given fraction of those earnings as dividends, then the dividend itself would tend to fluctuate drastically from year to year or quarter to quarter. These fluctuations would conflict with the objective of maintaining a stable dividend policy. On the other hand, if the dividend is a constant amount, then it will be a fluctuating proportion of earnings.
Assume that a corporation starts with a dividend target. If earnings are stable, then the dividend is unlikely to be changed. However, if earnings are increasing, then, with a constant dividend, the payout ratio will gradually decrease. If the increase in earnings is expected to be temporary, for example, as a result of some extraordinary event or unusually good business conditions, then it is unlikely that the company will change its dividend. However, if management believes that earnings are likely to be maintained at their new level or to increase even farther, then it is likely that the dividend will be increased. The increase will be in the direction of approaching the amount that the board of directors has set as a target payout ratio. Companies vary the payout ratio they select, and the speed with which they adjust the dividend of a period to changes in earnings; however, they tend to adhere to a target payout ratio. Over long periods of time, this policy tends to result in a dividend payout that is approximately equal to the payout target, but dividends tend to be more stable from year to year than earnings.
Assume that a firm has a large amount of desirable investments and that these investments require more funds than are...
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