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FACTORS EFFECTING DIVIDEND POLICIES

FACTORS EFFECTING DIVIDEND POLICIES

FACTORS EFFECTING Dividend POLICIES

Introduction:

Dividend policy of a company is the strategy followed to decide the amount of dividends and the timing of the payments. A firm’s dividend policy is influenced by the large numbers of factors.

Factors Affecting Dividend Policy:

Some factors affect the amount of dividend and some factors affect types of dividend. The following are the some major factors which influence the dividend policy of the firm.

  1. Growth and Profitability

The amount of growth a firm can sustain and its profitability is related to its dividend decisions, so long as the firm (because of managerially imposed to external market constraints) cannot issue additional equity.

Firms with strong growth prospects maintain low target payout ratios. In fact all the firms that experience above-average growth rates are expected to have low dividend payout ratios since, in line with the residual theory of dividends, a greater number of profitable investment opportunities should result (other things being equal in a greater need for earnings retention.

This interrelationship among the firm’s growth, its profitability, and its investment, financing, and dividend decisions cannot be overemphasized.

  1. Liquidity:

The liquidity position of a firm is often an important consideration in dividend decisions. Since dividends represent a cash outflow, it follows that the better the cash position and overall liquidity of the firm, the greater is the firm’s ability to pay (and maintain) a cash dividend.

A growing, profitable firm may not be liquid, since it needs funds for new capital expenditures and to build up its permanent working capital position.

Likewise, firms in cyclical industries may experience times when they lack liquidity due to general economic conditions. Hence, the degree of liquidity is a variable of concern when a firm’s dividend policy is being assessed.

  1. Cost and Availability of Alternative Forms of financing:

The ability of a firm to raise money externally will have a direct bearing on the level of dividends paid to shareholders. Clearly, a company that has easy access to the capital markets, and that can conveniently and economically raise funds in a number of alternative ways, will have greater latitude in setting dividend policy than a firm that has to rely heavily on earnings retention as a source of financing.

  1. Managerial Control:

In some cases, control of the firm may be a factor to consider when establishing dividend policy. Suppose a fairly substantial proportion of the firm is owned by a controlling group, and the remainder of the stock is publicly held. Under these circumstances, the higher the payout ratio, the more likely that a subsequent issue of equity may be needed to finance capital expenditures.

Those in control might prefer to minimize the likelihood of an offering of equity to avoid any dilution in their ownership position.

Hence, they would prefer a low payout policy. On the other hand, a firm may establish a relatively high dividend payout ratio (if it believes that is what shareholders desire) as a way to keep the firm from being acquired in a merger or acquisition.

  1. Legal Constraints:

The legal rules act as boundaries within which a company can declare dividends. In general, cash dividends must be paid from current earnings or from previous earnings that have been retained by the corporations after providing for depreciation. However, a company may be permitted to pay dividend in any financial year out of the profits of the company without providing for depreciation.

Though the dividends should be paid in cash, but it doesn’t prohibit a company from capitalizing its profits or reserves (retained earnings) for the purpose of issuing fully paid bonus shares (stock dividend).

  1. Access to the Capital Market:

Another matter for consideration by management in setting an appropriate dividend policy is the company’s ability to obtain cash on relatively short notice. This may be achieved by the company negotiating for a bank overdraft limit or having access to other short-term sources of funds.

However, if a company’s ability to make a new issue of shares or to issue debt is restricted, it is likely that it will retain a higher proportion of its profits than a company which has ready access to funds from the capital market.

Companies which are likely to have difficulties raising funds on the capital market include small companies, new companies, and companies in what may be termed venture capital fields.

  1. Inflation:

Inflation must be taken into account when a firm establishes its dividend policy. On the one hand, investors would like to receive larger cash dividends because of inflation.

But from the firm’s viewpoint, inflation causes it to have to invest substantially more to replace existing equipment, finance new capital expenditures, and meet permanent working capital needs. Thus, in inflationary times, there may be a tendency to hold down cash dividends.

  1. External Restrictions:

The protective covenants in a bond indenture or loan agreement often include a restriction on the payment of cash dividends. This restriction is imposed to preserve the firm’s ability to service its debt.

These restrictions may be in the form of coverage ratio, sinking fund etc. Presence of these restrictions forces a company to retain earnings and follow a low payout.

  1. Extent of share Distribution

Nature of ownership also affects the dividend decisions. A closely 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 a good number of shareholders widely distributed and forming low or medium income group would face a great difficulty in securing such assent because they will emphasize to distribute higher dividend.

  1. Needs for Additional Capital

It has also effect on the dividend policy of a company. 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 raising finance for their needs of increased working capital for expansion programs. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits.

  1. Trade Cycles

Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up.

  1. Government Policies

The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labor, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated.

  1. Taxation Policy 

High taxation reduces the earnings of the companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. Taxation policy also affects the capital formation of companies.

  1. Legal Requirements

In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled.

For example, payment of dividend on preference shares in priority over ordinary dividend. 

  1. Past dividend Rates

While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rate. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organization.

  1. Policy of Control

Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programs of the existing management. So they prefer to meet the needs through retained earnings. If the directors do not bother about the control of affairs then they will follow a liberal dividend policy.

  1. Repayments of Loan

A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout.

  1. 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.

  1. State of Capital Market:

When there is Favorable Market liberal dividend policy is applied. When there is Unfavorable market Conservative dividend policy is applied.

TYPES AND FORMS OF DIVIDEND POLICIES

There are basically 4 types of dividend policy. Let us discuss them on by one:

(1) Regular Dividend Policy:

In this type of dividend policy the investors get dividend at usual rate. Here the investors are generally retired persons or weaker section of the society who want to get regular income. This type of dividend payment can be maintained only if the company has regular earning.

Merits of Regular dividend policy:
  • It helps in creating confidence among the shareholders.
  • It stabilizes the market value of shares.
  • It helps in marinating the goodwill of the company.
  • It helps in giving regular income to the shareholders.

(2) Stable dividend policy:

Here the payment of certain sum of money is regularly paid to the shareholders. It is of three types:

  • (a) Constant dividend per share: Here reserve fund is created to pay fixed amount of dividend in the year when the earning of the company is not enough. It is suitable for the firms having stable earning.
  • (b) Constant payout ratio: It means the payment of fixed percentage of earning as dividend every year.
  • (c) Stable rupee dividend + extra dividend: it means the payment of low dividend per share constantly + extra dividend in the year when the company earns high profit.
Merits of stable dividend policy:
  • It helps in creating confidence among the shareholders.
  • It stabilizes the market value of shares.
  • It helps in marinating the goodwill of the company.
  • It helps in giving regular income to the shareholders.

3) Irregular dividend:

As the name suggests here the company does not pay regular dividend to the shareholders. The company uses this practice due to following reasons:

  • Due to uncertain earning of the company.
  • Due to lack of liquid resources.
  • The company sometime afraid of giving regular dividend.
  • Due to not so much successful business.

4) No dividend:

The company may use this type of dividend policy due to requirement of funds for the growth of the company or for the working capital requirement.

OTHER FORMS

Dividends – Stock Repurchase

Stock repurchase may be viewed as an alternative to paying dividends in that it is another method of returning cash to investors. A stock repurchase occurs when a company asks stockholders to tender their shares for repurchase by the company. There are several reasons why a stock repurchase can increase value for stockholders. First, a repurchase can be used to restructure the company’s capital structure without increasing the company’s debt load. Additionally, rather than a company changing its dividend policy, it can offer value to its stockholders through stock repurchases, keeping in mind that capital gains taxes are lower than taxes on dividends.

Stock Splits

Stock splits occur when a company perceives that its stock price may be too high. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range.

Stock splits increase the number of shares outstanding and reduce the par or stated value per share of the company’s stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. The split will double the number of shares outstanding and reduce by half the par value per share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional ownership represented by the shares. For example, a shareholder owning 2,000 shares out of 100,000 before a stock split would own 4,000 shares out of 200,000 after a stock split.

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