Dividend Policy

 A 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 investments and bearing risks.

Dividend policy is simply concerned with determining the portion of a firm’s earnings into dividends and retained earnings in the firm. A firm’s dividend policy is influenced by a large numbers of factors. Some factors affect the number of dividends and some factors affect the types of dividends.

A dividend policy refers to how a company structures its dividend payouts to shareholders. According to some researchers, the dividend policy is irrelevant, in theory, since investors may be able to sell a part of their shares or portfolio when they need cash.

The dividend irrelevance theory holds that dividend payouts have little impact on stock prices. However, whether the dividend policy is relevant or not, it is a source of income for shareholders. A generous dividend policy often benefits company leaders, who are often the largest shareholders.

Dividend policies are viewed by most companies as integral to their corporate strategies. Dividend payments are influenced by many factors, including the amount, timing, and other factors. Dividend policies are divided into three types: the constant dividend policy, the stable dividend policy, and the residual dividend policy.

Types of Dividend Policies

Some of the types of dividend policies are as follows:

• Stable Dividend Policy

The easiest and most common dividend policy is a stable dividend policy. The policy aims for a steady and predictable dividend payout every year, which is what most investors desire. Dividends are paid regardless of earnings growth or decline.

Dividend policy should be aligned with the long-term growth potential of the company rather than with quarterly earnings volatility. As a result, the shareholder can be more certain about the amount and timing of the dividend.

• Constant Dividend Policy

The main disadvantage of the stable dividend policy is that investors may not see dividend increases in boom years. Dividends are paid by a company under the constant dividend policy as a percentage of its earnings.

This allows investors to experience all of the company’s earnings volatility. Investors may receive a dividend if earnings are up, but not if earnings are down.

This method has the primary drawback of causing earnings and dividends to fluctuate. When dividend income fluctuates widely, it can be difficult to plan financially.

• Residual Dividend Policy

A dividend policy that pays residual dividends is also highly volatile, but some investors believe it to be the only policy they can accept. When a company has a residual dividend policy, it pays out the dividends that are left over after paying for capital expenditures and working capital.

Despite this approach’s volatility, it makes the most sense as a business operation. Investing in a company that justifies its increased debt with dividends is not attractive to investors.

Factors Affecting Dividend Policy

The dividend policy of a firm is a critical decision that involves determining how much of the company’s earnings will be distributed to shareholders in the form of dividends and how much will be retained for reinvestment in the business. Several factors can influence a firm’s dividend policy, and these factors can vary from one company to another. Here is a breakdown of the factors affecting dividend policy:

Some of the factors affecting dividend policy are as follows:

Legal Requirements

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

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

• Legal regulations in a company’s jurisdiction may require a minimum dividend payout or restrict dividend payments during certain financial situations.
• Compliance with these regulations is crucial, and failure to do so can result in legal penalties.

Firm’s liquidity position and Liquidity of Funds

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

Dividend decisions are influenced by the liquidity of funds. Profit is a factor of accounting and a legal requirement, while the company’s working capital and cash position are also necessary factors to determine whether it is able to pay dividends.

Dividends are paid out of cash, and therefore, the firm’s investment and financing decisions determine its cash position and liquidity. Investment decisions determine the rate of asset expansion and the firm’s ability to raise funds, whereas financing decisions determine the method of financing.

• The availability of liquid funds plays a significant role in determining a firm’s ability to pay dividends.
• If a firm has limited cash reserves or faces short-term liquidity issues, it may choose to retain earnings rather than pay dividends.

Repayment Need

A firm uses several forms of debt financing to meet its investment needs. These debts must be repaid at 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 first pays a payment to all the debt, and if remains then provide a dividend.

• If a company has significant debt obligations, it may prioritize using its available funds to meet debt repayment requirements over paying dividends.
• Debt covenants may also restrict a company’s ability to distribute dividends until certain financial ratios are met.

Expected rate of return

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

• Companies often consider investment opportunities with higher expected rates of return. If they have profitable investment projects, they may choose to reinvest earnings instead of paying dividends.

Stability of earning

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

Desire of control

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

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.

• A firm’s ability to raise capital from the capital market can affect its dividend policy. If it can easily raise funds through equity issuance, it may be more inclined to pay dividends.
• Conversely, if accessing capital is costly or difficult, the firm may choose to conserve cash and pay lower dividends.

Shareholder‘s individual tax situation

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

• Different shareholders may have varying tax situations. Some investors prefer capital gains (which are typically taxed at a lower rate) over dividends (which can be subject to higher taxes).
• The tax considerations of the shareholders may influence the company’s dividend policy.

Financing Policy of the Company

A company’s dividend policy may be impacted and influenced by its financing policy. As a result, it will have to pay less dividends to shareholders if it decides to meet its expenses from its earnings.

However, if the company feels that borrowing from outside is cheaper than internal financing, then it might choose to pay its shareholders a higher dividend rate. Thus, the dividend policy of the business firm is influenced by the internal financing policy of the company.

• The firm’s overall financing strategy can impact dividend decisions. If a company relies heavily on equity financing, it may be more inclined to pay dividends to attract investors.
• Conversely, if the company prefers debt financing, it may prioritize debt service over dividends.

Past Dividend Rates

The dividend rate may be determined on the basis of the dividends declared in the previous year if the firm already exists. It is better for the company if the dividend rate remains stable, so generally the directors should take into account the past dividend rate.

• A firm’s historical dividend payments can set expectations among shareholders. Companies often aim for stability in dividend payments to avoid surprising investors.

Debt Obligations

Firms that have incurred heavy debt are not able to pay higher dividends to shareholders. Retaining earnings after a substantial debt reduction program is critical for such concerns. Conversely, if the company has no debt obligations, it can afford to pay a higher dividend rate.

• The terms of existing debt agreements may restrict or influence dividend payouts. Debt covenants often include clauses related to dividend payments and financial performance.

Policy of Control

Dividend policy is also influenced by the policy of control. It will have to pay less dividends if the company does not feel new shareholders should be added. There is generally a belief that new shareholders can reduce management’s control over the concern.

As a result, if maintaining existing control is a priority, the dividend rate may be lower so that the company can meet its financial needs from retained earnings without issuing new shares to the public.

• If management or a controlling shareholder has a significant stake in the company, they may influence dividend decisions to retain control or achieve specific objectives.

Corporate Taxation Policy

The rate of dividends of a corporation is affected by corporate taxes. Tax rates are high, which reduces residual profits available for distribution to shareholders. Consequently, dividend rates are affected.

Additionally, the government may place a dividend tax on distributions of dividends beyond a certain threshold. Dividend rates may be affected as a result.

• The tax laws in a company’s jurisdiction can impact the after-tax cost of dividends. Companies may adjust their dividend policies to optimize tax efficiency.

Similarly, You may Also like:

• Types of Dividends – Meaning, Examples, Advantages, Disadvantages, Methods | Accounting for Dividend
• Stock Dividend – Why do companies give stock dividends? | Financial Management

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Smirti

(Founder of Management Notes)
MBA,BBA.

I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.

I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,

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