Dividend policy is the decision for the firm to pay out earnings verses retaining and reinvesting them. Dividend decision has remained one of the tough challenges for financial economists. We are yet to understand completely the factors that influence dividend decision and the manner in which these factors interact.
From the practitioner’s viewpoint dividend policy of a firm has an implication for investors, managers, lenders and other stakeholders. For investors, dividends whether declared today or accumulated and provided at a later date are not only a means of regular income, but also an important input in valuation of a firm. Similarly, manager’s flexibility to invest in projects is also dependent on the amount of dividend that they can offer to shareholders as more dividends may mean fewer funds available for investment. Lenders may also have interest in the amount of dividend firm declares, as more the dividend paid less would be the amount available for servicing and redemption of their claims.
At the end of each year, every publicly traded company has to decide whether to return cash to its stockholders, and if yes, and how much in the form of dividends. The owner of a private company has to make a similar decision about how much cash he plans to with draw from the business, and how much he has to reinvest, this we called the dividend decision. Factors That Influence Dividend
Following are the factors involved in formulating dividend policy. 1. Legal Constraints:
Most states prohibits companies from paying out as cash dividends any portion of the firm’s legal capital, which is measured by the par value of common stock. Other states define legal capital to include not only the par value of the common stock, but also any-paid in –capital in excess of par. These capital impairment restrictions are generally established to provide a sufficient equity base to protect creditor’s claims. 2. Contractual Constraints:
Often, the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan agreement. Generally, these constraints prohibit the payment of cash dividends until a certain level of earnings have been achieved, or they may limit dividends to a certain amount or a percentage of earnings. Constraints on dividends help to protect creditors from losses due to the firm’s insolvency. The violation of a contractual constraint is generally grounds for a demand of immediate payment by the funds supplier. 3. Internal Constraints:
The firm’s ability to pay cash dividends is generally constrained by the amount of excess cash available rather than the level of retained earnings against which to charge them. Although it is possible for a firm to borrow funds to pay dividends, lenders are generally reluctant to make such loans because they produce no tangible or operating benefits that will help the firm repay the loan. Although the firm may have high earnings, its ability to pay dividends may be constrained by a low level of liquid assets. (Cash and marketable securities). 4. Growth Prospects:
The firm’s financial requirements are directly related to the anticipated degree of asset expansion. If the firm is in a growth stage, it may need all its funds to finance capital expenditures. Firms exhibiting little or no growth may never need replace or renew assets. A growth firm is likely to have to depend heavily on internal financing through retained earnings, as dividends. 5. Owner Considerations:
You know that in establishing a dividend policy, the firm’s primary concern should be to maximize shareholder’s wealth. One such consideration is then tax status of a firm’s owners. Suppose that if a firm has a large percentage of wealthy stockholders who are in a high tax bracket, it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payments of taxes until they sell the stock. Of course, when the stock is sold, the...
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