Dividend Policy

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Dividend Policy
Factors Affecting Dividend Policy: 
1. External Factors 
2. Internal Factors 
External Factors Affecting Dividend Policy
1. General State of Economy:
* In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks. * In the period of depression the management may also retain a large part of its earnings to preserve the firm's liquidity position. * In periods of prosperity the management may not be liberal in dividend payments because of availability of larger profitable investment opportunities. * In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines.

2. State of Capital Market:
* Favourable Market: liberal dividend policy.
* Unfavourable market: Conservative dividend policy.

3. Legal Restrictions:
Companies Act has laid down various restrictions regarding the declaration of dividend: * Dividends can only be paid out of:
* ** Current or past profits of the company.
* Money provided by the State/ Central Government in pursuance of the guarantee given by the Government. * Payment of dividend out of capital is illegal.
* A company cannot declare dividends unless:
* ** It has provided for present as well as all arrears of depreciation. * Certain percentage of net profits has been transferred to the reserve of the company. * Past accumulated profits can be used for declaration of dividends only as per the rules framed by the Central Government

4. Contractual Restrictions:
Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems)  Example: 
A loan agreement that the firm shall not declare any dividend so long as the liquidity ratio is less than 1:1.  The firm will not pay dividend more than 20% so long as it does not clear the loan. 

Internal Factors affecting dividend decisions
1. Desire of the Shareholders:
Though the directors decide the rate of dividend, it is always at the interest of the shareholders.  Shareholders expect two types of returns: 
[i] Capital Gains: i.e., an increase in the market value of shares.  [ii] Dividends: regular return on their investment.
Cautious investors look for dividends because, 
[i] It reduces uncertainty (capital gains are uncertain). 
[ii] Indication of financial strength of the company. 
[iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses. 2. Financial Needs of the Company:
If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 3. Nature of earnings:
A company which has stable earnings can afford to have an higher divided payout ratio 4. Desire to retain the control of management:
Additional public issue of share will dilute the control of management. 5. Liquidity position:
Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends 

 
4. Extent of share Distribution.
 Nature of ownership also affects the dividend decisions. Aclosely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having agood number of shareholders widely distributed and forming low or medium income group,would face a great difficulty in securing such assent because they will emphasise to distributehigher dividend. 5. Needs for Additional Capital. Companies

retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raisingfinance for their needs of increased working capital for expansion...
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