Factors Affecting Dividend Policy Of a Firm| Financial Management

Factors Affecting Dividend Policy Of a Firm
Dividend Policy | Financial Management
BBA | BBA-BI
Management Notes

Dividend is the distribution of profit or the portion of net income paid out to shareholders. It is paid to shareholders in cash or stock for making investment and bearing risk. Dividend policy is simply concerned with determining the portion of firm’s earning into dividend and retained earnings in the firm.
A firm’s dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types of dividend. The following are some of the major factors which influence the dividend policy of the firm.

1. Legal requirements:

For any company ,there is no legal compulsion to distribute dividend. However, there certain condition imposed by law regarding the way dividend is distributed.
Basically there are three rules relating to dividend payments.

• Net profit rule: According to this rule , if the company is in profit during the current year , it pays dividend and if it is in loss then it does not.
• The capital impairment rule: According to this rule, firm cannot pay dividend out of its paid in capital because it affects the firm’s equity base as they are kept to protect claim of creditors by maintaining sufficient equity base.
• Insolvency rule: According to this rule , if firms total asset is less than its total liability then it cannot pay dividend as the firm is considered to be financially insolvent.

2. Firm’s liquidity position:

Dividend pay-out is also affected by firm’s liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash. In this case the firm or company declares stock dividend instead of cash dividend.

3. Repayment need:

A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity of the firm reduces. Therefore, the firm firstly pays payment to all the debt and if remains then provides dividend.

4. Expected rate of return:

If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning:

If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control:

When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.

7. Access to the capital market:

If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm’s dividend payment capacity becomes high.

8. Shareholder’s individual tax situation:

For a closely held company, stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend gains. It is because the tax rate on cash dividend is higher than on capital gain.