Everything you need to know about the determinants of dividend policy. Dividend policy determines the allocation of earnings payable to shareholders and earnings to be retained. As such, the policy framed by the management regarding the distribution of earnings to the shareholders as dividend is known as dividend policy. It is not related to dividend payable only in a specific year; rather it is related to steps to be followed/adopted for a number of years.
A: Top 11 determinants of dividend policy for a firm are:- 1. Shareholders’ Expectations 2. Type of Company 3. Financial Needs of the Company 4. Legal Restrictions 5. Liquidity 6. Access to the Capital Market 7. Restrictions by Creditors 8. Control 9. Inflation 10. Dividend Payout Ratio 11. Insolvency.
B: Top 11 factors affecting the dividend policy of a firm are as follows:- 1. Funding Needs 2. Legal Restrictions 3. Liquidity 4. Ownership Control 5. Ability to Borrow 6. Nature of Earnings 7. Past Dividend Declarations 8. Shareholders’ Expectations 9. State of Capital Markets 10. General Economic Environment 11. Taxation Policies.
C: The determinants of dividend policy include:- 1. Transaction Costs 2. Personal Taxation 3. Dividend Clientele 4. Dividend Signalling 5. Dividend Payout 6. Dividend Cover 7. Divisible Profits 8. Liquidity 9. Rate of Expansion 10. Rate of Return 11. Stability of Earnings 12. Stability of Dividends 13. Legal Provisions 14. Contractual Constraints 15. Cost of Financing 16. Degree of Control 17. Capital Market Access 18. State of Economy.
D: Factors affecting the dividend policy may be put in three categories:- 1. Ownership Factors 2. Company-Oriented Factors 3. Other Factors.
Determinants of Dividend Policy for a Firm and Company
Determinants of Dividend Policy – Top 11 Determinants of Dividend Policy For a Firm
A firm can distribute dividends either in the form of cash dividends, or bonus shares. But the tax treatment for these sources of income is different. Cash dividend is added to the total income, whereas capital gains are treated as a source of income with concessional tax treatment. Therefore, shareholders preference for cash dividends or bonus shares depends on their economic status, and the effect of income tax on cash dividends and capital gains,
The shareholders (or investors) can be divided into four groups:
(a) Small investors
(b) Retired people
(c) Wealthy investors, and
(d) Institutional investors
(a) Small Investors – They do not have a definite investment policy. They will buy shares when they have some excess cash with them. The decision may be based on friends advise, or to reduce the tax liability. But they generally prefer cash dividend.
(b) Retired People – Retired people view dividends as a source of funds to meet their current living expenses, so they prefer cash dividends.
(c) Wealthy Investors – They buy shares to get the controlling rights in the company. Since they are in the high income tax bracket, cash dividends further increase their tax liability. So they want to minimise their tax liability, therefore, they prefer bonus shares, which allows concessional tax treatment.
(d) Institutional Investors – Institutional investors are insurance companies, unit trust, general insurance companies etc., with sizeable portion of investible funds, representing a significant force in the financial market. The earnings for institutional investors, will affect its dividends to its shareholders also. So institutional investors prefer to get regular cash dividend and capital gains when they sell the securities.
In the case of closely held companies, the preferences of the shareholders are usually known to the management. Therefore, they can easily adopt a dividend policy which satisfies all the shareholders. Generally, shareholders in the closely held companies are in the high tax brackets; therefore, they prefer capital gains to current dividend incomes. So the closely held companies can establish a dividend policy of paying less or no dividends, and retaining the earnings within the company.
But in the case, of widely held companies, it is not easy to satisfy different groups of shareholders. Therefore the directors will decide a dividend policy giving consideration to all groups of shareholders. Generally, it is found that these companies follow a stable dividend policy, because wide variation in dividend rates over the years, may lose the confidence of present and prospective shareholders, the general public, and whosoever who wants to have dealings with the company.
Determinant # 3. Financial Needs of the Company:
The firm’s financial requirements are directly related to its investment needs, that is, the firm should formulate its dividend policy on the basis of its future investment needs. If the firm has abundant investment opportunities, it should prefer less dividend payments, because the firm can invest the funds. Usually growth firms are constantly in need of funds, and they prefer to retain profits.
Similarly, retention of earnings is convenient and less costly than new issue, because there is no flotation expenses associated with retained earnings. However, if the firm has little or no growth opportunities, it will probably prefer to distribute dividends than retention.
As per the provisions of the Companies Act 1956, it is compulsory that firms should provide for depreciation before declaring dividend. Moreover by an amendment of the Companies Act on December 28th 1960, it has been made compulsory, that not only depreciation, but also arrears of depreciation be also provided before declaring dividend. (Section 205 (1) of the Companies Act. So, from then onwards if any company wants to declare dividend, then depreciation and arrears of depreciation are to be provided –
(a) Either out of profits of that financial year, or
(b) Out of profits for any other previous financial year to years.
But there are two exceptions to this rule:
(a) Profit earned before December 28th 1960 may be distributed, and
(b) The Central Government can allow a company to declare dividend without providing depreciation and arrears of depreciation, in the best public interest. For example- in the case of a sick company, in order to satisfy the shareholders, the central government may give permission to the company to distribute dividend, without providing for depreciation and arrears of depreciation.
Determinant # 5. Liquidity:
Cash position of a firm is an important consideration in paying dividends, because payment of dividends means cash out flow. An established company is generally liquid and is able to pay large amount of dividend. On the other hand, a growing firm faces the problem of liquidity. Therefore, even though it makes good profits, due to insufficient cash for its investment opportunities, the management may not be able to declare dividends.
The firm’s dividend policy is also related to the availability of funds, its ability to raise funds from the capital market and the costs involved in obtaining the funds. For a well-established and reputed company it may not be difficult to raise funds in the capital market. So these companies can pay dividends, because their financial needs if required can be met from the capital market.
But a growing firm which has only little access to the capital market will not be able to pay dividend often, because its financial needs cannot be completely met from the capital market.
Important restrictions on the payment of dividend may be accepted by a company, at the time of obtaining loans from financial institutions, debenture capital, preference capital, or for a lease agreement. In such a situation, creditors may ask the company to restrict the payment of cash dividends until a certain level of profits are earned, or to limit the amount of dividend, to a certain percentage of earnings.
If the conditions of the creditors are violated, they may ask the firm to repay the entire amount with interest. So the amount of dividends payable, is dependent on the terms and conditions accepted to the creditors.
Another factor affecting the dividend policy decision of the firm is the management’s desire to control the company. The management, in order to retain control of the company in their own hands, may prefer to retain profits rather than paying dividends, because the control of the existing shareholders will get diluted if the company issues new shares. This is particularly true for companies when an outside group is trying to take control of the firm by buying shares.
On the other hand, if the management has absolute control of the firm, either through substantial shareholdings, or because the shares are widely held and the firm is a reputed one, then it can distribute cash dividends, since its additional financial needs can be met immediately, owing to its reputation.
This is another factor which affects the firm’s dividend decision. As per the accounting concept, assets are recorded at the price at which it is acquired by the firm in the books of accounts. But due to inflation, when the assets are to be replaced, there will be a wide variation between the funds set apart for that purpose with the market value. Therefore, in order to maintain the capital intact, companies may prefer to retain earnings.
This is another important factor affecting the dividend decision of a firm. Dividend payout ratio means the percentage share of the net earnings distributed to the shareholders as dividend. It is found that generally the shareholders’ prefer a stable dividend policy because wide variation in dividend rates over the years may cause a loss of confidence of present and prospective shareholders and the general public or whosoever wants to have dealings with the company. Therefore companies usually keep a stable dividend payout ratio.
A firm is said to be insolvent in two situations, that is when its liabilities exceed the assets, or when it is unable to meet its payments. If the firm is currently insolvent in either way, it is prohibited from paying dividends. Similarly the firm would not pay dividend, if such a payment leads to insolvency of the firm. This step is to protect the firm’s creditors by prohibiting the liquidation of the company.
Determinants of Dividend Policy: Top 11 Factors Affecting the Dividend Policy of a Firm
When a firm decides its dividend policy, it considers a numbers of matters. In addition to consideration of these matters, other factors also influence the dividend policy of a firm.
The important factors affecting the dividend policy of a firm given below:
1. Funding Needs of the Firm:
A firm should consider the financial needs for expansion of business or financial needs for increased working capital before making the dividend decision. If the firm distributes all profits as dividend to shareholders, it may face difficulties in expanding the business by taking new profitable projects.
The no retention of profits may also hamper the smooth functioning of business of the firm, in case there arises requirement for increased working capital. Thus, before declaring the dividend the management of the firm should consider the future financial requirements.
2. Legal Restrictions:
Before the declaration of dividend, the management of the firm has to abide by the various legal requirements. There are various provisions regarding the declaration of dividend in the Companies Act, which are to be followed at the time of declaration of dividend. These legal restrictions play a role in establishing the dividend policy of a firm.
Since dividends represent out flow of cash, the strong cash position and liquidity are a precondition in declaring the dividend. The profitability of a firm is different from its liquidity. Stronger the liquidity position of a firm, higher is its ability to pay the cash dividends. The firms having a strong liquidity position may able to pay dividends despite having low profits.
4. Ownership Control:
The dividend policy of a firm is influenced by ownership motive. If the firm is not interested in the dilution of control, it will have to have low pay-outs in its dividend policy. In such a case, the firm can use retained earnings for future expansion or working requirements without raising the additional equity capital.
On the other hand, if a firm pays high dividends without retaining much profit, it will have to go the capital markets to finance its expansion plans. Then, raising of new equity capital will increase the number of shareholders and the control of the firm will get diluted. Thus, the ownership motive of the firm will influence its dividend policy.
5. Ability to Borrow:
If a firm has the ability to borrow on comparatively short notice, it may be financially more flexible. The larger and more established a firm, more is the reputation of the firm and the better is its access to the capital market. The greater the ability of the firm to borrow, the greater its financial flexibility and greater its ability to pay a cash dividend.
With easy access to the capital markets, the management can easily pay cash dividends. Such firms can adopt the stable dividend policy. The firms can maintain a low retention ratio. Thus, the ability of a firm to borrow easily from market is decisive factor in deciding the dividend policy of a firm.
6. Nature of Earnings:
If the earnings of a firm are stable, it is easy to predict future earnings of the firm. Such firms can pay higher dividends and can maintain low profit retention ratio. On the other hand, if a firm has fluctuating earnings, it difficult to predict its future earnings. Such a firm has to maintain high profit retention ratio. The payout ratio of such firms will be low. Thus, stability in earnings plays a role in constructing the dividend policy of a firm.
7. Past Dividend Declarations:
Generally, companies maintain consistency in dividend payments. If an existing company recommends a significantly increased dividend, it causes speculation in the shares of company. The significant deviation in dividend rate of a company is averse to investors’ expectations. Hence, while constructing the dividend policy of a firm, consistency in dividend rate should be maintained.
8. Shareholders’ Expectations:
When investors invest their funds in the shares of a firm, they make certain expectations about dividend payments. Now, if the firm overlook their expectation in declaring dividend rate, it may face two problems. First, if there is sudden downfall in dividend rate, investors will switch to another firm paying higher dividends.
This will cause a decline in market price of shares and the value of the firm will decline. This will defeat the very purpose of the firm i.e., maximisation of shareholders’ wealth. Second, unstable dividend policy of the firm may damage the reputation of the firm in the market.
If this happens, the firm may face difficulties in raising the funds from the market in future. Thus, while constructing the dividend policy a firm cannot ignore the expectations of investors regarding the dividend rate.
9. State of Capital Markets:
The access of a firm to capital market and the state of capital market have an important bearing on decision of dividend rate taken by board of the firm. If the firm has easy access to capital market, it can take a decision to pay high dividends. Otherwise, not having an easy access to capital market, the firm have to construct conservative dividend policy.
The state of capital market also influence the dividend rate declared by a firm. In case the market condition is good, the firm may declare a high dividend rate. On the other hand, if market conditions are not good, the firm should adopt a conservative dividend policy by retaining the profits for future use.
10. General Economic Environment:
The dividend policy of a firm has to be constructed according to the economic policies of government. Sometimes, government fixes the limit of dividend rate to be declared by a firm.
The prevailing economic condition also influence the dividend rate decided by a firm. If the rate of inflation is high in country, the firm should declare high rate of dividends. On the other hand, if the prevailing rate of inflation is low, then a low rate of dividend can be recommended.
11. Taxation Policies:
The corporate taxation policy of government affects the rate dividends of firms. The high rate of corporate taxation, reduces the residual profits after tax available to shareholders. As a result, the rate of dividend is affected.
The direct tax rates also influence the rate of dividend. If income tax rate are high, shareholders would insist the board of directors to pay dividend in kind and not in cash. They may prefer stock dividend and capital gains.
Thus, the rate of dividend and type of dividend are influenced by the taxation policies of the government.
Determinants of Dividend Policy – Transaction Cost, Personal Taxation, Dividend Clientele and Signalling
1. Transaction Costs:
The transaction costs are of two different types:
a. Firm’s Transaction Costs:
The costs incurred in raising new capital are called ‘flotation costs’ and it is ranging as high as 10% of the amount raised. The flotation costs associated with raising new funds give firms an incentive to avoid paying dividends.
b. Shareholders’ Transaction Costs:
When a stock is sold, the investor must pay transaction costs of approximately 1-2% of the share’s value. The firm may be able to provide investors with dividend income at a lower transaction cost than if the investors provided income for themselves.
2. Personal Taxation:
Dividend payments to individuals are subject to personal taxation in the year received. At the time of selling the shares, the investor will be attracted with capital gains. By paying dividends, a corporation is forcing its stockholders to have to pay taxes earlier than they would if the dividends were not paid.
3. Dividend Clientele:
Firms with different dividend policies will appeal to different kinds of investors, with each group constituting a different dividend clientele. A dividend clientele is a group of investors favouring a particular kind of dividend policy. Low and zero tax payers appear to prefer high payout ratios, while high taxation groups prefer low dividends and expect to realize benefits through capital gains.
4. Dividend Signalling:
It has been observed that an increase in the dividend is often accompanied by an increase in the price of the stock, while a dividend cut generally leads to a stock price decline. The companies, in practice appear to place great emphasis on last year’s dividend when deciding the current year’s dividend.
Dividends tend to be more stable than earnings; companies appear to pursue some long-term payout ratio and dividends are changed in line with expected future net cash flows. Changes in dividend policy may convey information to the stock market. An increase in dividends is likely to be interpreted as ‘good news’ and a cut as ‘bad news’.
The complete skip-off of a dividend is likely to be regarded as very bad news. The companies use this information channel to inform the investors. According to the dividend signalling hypothesis, dividend changes provide an effective way of allowing management to convey believable information to the market about the firm’s expected future cash flows.
By conveying the favourable information to the market in a believable way, the dividend decision may effect the value of the firm. The impact of dividend announcement on share price is shown in figure 18.1.
5. Dividend Payout Ratio:
Determination of dividend payout ratio is one of the major financial decisions effecting the firm’s wealth as well as market price of the share. Dividend payout ratio represents the percentage of dividend declared and paid out of the earnings per share.
Dividend payout indicates the extent of the net profits distributed to the shareholders as dividend. A high payout ratio signifies a liberal distribution policy drives down the cash resources available with the company. A low payout ratio indicates conservative distribution policy, which enables the firm to accumulate internal resources for future capital expenditure, growth and diversification, which will result in long-run capital appreciation of share price and maximization of firm’s wealth.
A low dividend payout will cause to depress the market price of the share. The management should strike a balance between current dividends and future growth and should ascertain an optimum dividend payout ratio.
6. Dividend Cover:
The dividend cover is calculated as follows:
This ratio indicates the number of times the dividends are covered by net profit. This highlights the amount retained by a company for financing its future operations.
7. Divisible Profits:
All the profits of a company are not divisible. Only those profits which can be legally distributed in the form of dividend to the shareholders of the company are called as “divisible profits”, otherwise, it is treated as payment of dividend out of capital and the directors of the company are liable to make it good.
Capital profits may only be used for dividend where the Articles permit and there is a bona fide revaluation of all the assets of the company and the profit has to be converted into cash i.e., realized.
In order to pay dividend, a company requires cash and, therefore, the availability of cash resources within the company will be a factor in determining dividend payments. It is not necessarily mean a highly profitable situation as the company with large amounts of cash at its disposal.
The liquidity position of the company will influence the dividend payout of a particular year. Before paying dividend the company should consider its financial commitments in repayment of loans and provide sufficient funds for meeting working capital requirements.
9. Rate of Expansion:
The rate of asset expansion needs to be taken into account. The more rapid the rate at which the firm is growing, the greater will be its needs for financing asset expansion. The greater the future need for funds, the more likely the firm is to retain earnings rather than pay them out.
If a firm seeks to raise funds externally, natural sources are the present shareholders who already know the company, yet if earnings are paid out as dividends and are subjected to high personal income-tax rates, only a portion of the earnings would be available for reinvestment.
10. Rate of Return:
Profit rate influences the dividend/retention policy. The rate of return on assets determines the relative attractiveness of paying out earnings in the form of dividends to shareholders who will use them elsewhere, compared with the productivity of their use in the present enterprise.
11. Stability of Earnings:
The stability of earnings also effects the decision. If earnings are relatively stable, a firm is better able to predict what its future earnings will be. A stable firm is, therefore, more likely to pay out a higher percentage of its earnings than is a firm with fluctuating earnings. The unstable firm is not certain that in subsequent years the hopes for earnings will be realized, so it is more likely to retain a high proportion of earnings.
12. Stability of Dividends:
The stability of dividends ensures the consistency of future stream of income to the shareholders. Small shareholders generally do not prefer variability in their future earnings in the form of dividends, they require a stable dividend policy.
The stability of dividends signals the efficient and profitable working of the company, increases the marketability of company’s securities, increases the stock market price of the share, help in raising funds for future investment proposals. Stability of dividends increases the investors’ confidence in company’s performance.
13. Legal Provisions:
The company has to comply with the provisions of the Companies Act, 1956 for payment of dividends. As per the provisions, the company must earn distributable profits from which the actual payment of dividends are made. A company must transfer a certain percentage of profits of current year to reserves, before declaring a dividend. A company can declare dividend out of reserves if current profits are not adequate, subject to legal provisions.
The provisions of Income-tax Act are applicable for deduction of tax at source. The companies should comply with SEBI guidelines for issue of bonus shares. The payment of dividend should not lead to impairment of capital. During the insolvency process, a company is prohibited to pay dividends. The Companies Act allows a company can pay interest out of capital during construction period of a project.
14. Contractual Constraints:
When the company obtained loan funds from debenture holders or term lending institutions, the terms of issue or contract of loan may contain restrictions on dividend payments designed to ensure that the firm will have enough funds to meet its obligations to the loan providers.
15. Cost of Financing:
The cost of external financing will have impact on the dividend payout of a company. In situations where the external funds are costlier, a firm may resort to low dividend payout and use the internal funds for financing its business.
16. Degree of Control:
The management who wish to maintain close control over the firm will not much depend on the external sources of finance, and they maintain a low dividend payout policy and the funds generated from operations would be used for working capital and capital investment needs of the firm. The use of retained earnings to finance new projects preserves the company’s ownership and control.
17. Capital Market Access:
A firm intends to raise further funds from the capital market for its expansion and diversification projects, to attract the funds from the capital market, it has to maintain a liberal dividend policy. The investment decisions of a general investor will be influenced by the firm’s dividend policies.
18. State of Economy:
When state of economy is uncertain, both political and economic, the firm may maintain a low dividend payout policy, to withstand to the business risks. The capital market conditions, rate of inflation, monetary and fiscal policy of the government will also influence the dividend policy. In case of high inflation conditions, the fixed assets are generally replaced with the retained earnings rather than raising external finances.
Determinants of Dividend Policy – Ownership Factors, Company-Oriented Factors and Other Factors
It is to be observed that the Dividend Policy is related only to equity shares because dividend on preference shares is paid at a prescribed rate. The dividend policy of a company comprises all aspects of dividend payments such as stability of dividend rate, time of payment, methods of payment, forms of payment, etc. While formulating dividend policy covering all these aspects, one has to study carefully not only the company’s requirements but also the interests of the shareholders. Some other economic factors are also to be considered.
Thus, factors affecting the dividend policy may be put in three categories:
(A) Ownership factors or ownership considerations (factors affecting the welfare of the shareholders).
(B) Company-oriented factors or considerations (factors affecting the welfare of the company).
(C) Other factors.
Normally, any decision, which is useful and profitable for the company, should also be beneficial to the shareholders. But this concept will hold true only when owners’ requirements and expectations as well as company’s interests are coextensive to each other. Prima facie there appears to be a conflict between the two because in the case of company form of organisation, there is separation between ownership and control.
1. Ownership Factors:
If the ownership is concentrated in few people, there are no problems in identifying the ownership interests. However, where the ownership is decentralised and wide (as in the case of public companies) the identification of their interests becomes difficult.
Again, the impact of shareholders’ interests on dividend decision becomes more uncertain when the preferences or status of shareholders with regard to their position, current income, capital gains, etc., may not exactly be ascertained or measured; also when there arises a conflict in shareholders’ interests. In spite of these difficulties, the formulation of dividend policy should be done keeping into account the shareholders’ interests.
Efforts should be made to ascertain the following interests of shareholders to encourage market acceptance of the shares:
(i) Current Income Requirements of the Shareholders:
Primarily a business enterprise is being set-up and operated for the profit to its owners, i.e., shareholders in the case of company. Thus, it seems logical to surmise that current income requirement of the shareholders will greatly affect the dividend policy. It can be found through research investigation as to which group of the shareholders has how much income requirements and with what velocity.
Few shareholders fulfill their income requirements by receiving dividend and to some extent by selling a portion of their shareholdings and earning what is called capital gains. Moreover, shareholders do not have any legal right to receive dividend only by purchasing the shares and at the same time directors have no responsibility to fulfill the income needs of the shareholders. But due to dividend policy followed in the past, Board of Directors does have a moral duty to maintain the form of dividend payments.
The real impact of current income requirements of the shareholders on the dividend policy may be evaluated with reference to the attitudes of the directors as well as form of share-ownership. Sometimes, the income requirements of the owners may be secondary as compared to company’s own requirements. Even then ownership requirements have to be considered while framing dividend policy only because it was done in the past.
On the contrary, the owners’ income requirements may be ignored in the formulation of dividend policy in spite of owners’ interest being supreme. In fact, when income requirements of the shareholders are the same and they have control over the company as well, only in that case owners’ income requirements play important role in framing the dividend policy.
(ii) Alternative Uses of Funds by Shareholders:
It is surmised under Dividend Policy that the portion of income, which is not distributed as dividend, is retained in the interests of ownership. It is also argued that the directors retain and plough back the profit only when the return on that retained earnings is expected to be higher than the return which the shareholders may receive from the alternate uses of that earnings. In other words, it is to be ascertained as how much income the shareholders could earn on the investments made by them of whole earnings distributed to them as dividends.
When the directors believe that by using the earnings in business itself the profit could be earned more than the profit on the alternative uses by the shareholders, they retain the earnings. However, it is very difficult to ascertain the minimum return from the alternative uses made by the shareholders.
The average shareholder himself does not know as how and where to use the amount of dividend given to him instead of being retained in the business. Moreover, the rate of return from the alternative uses by the shareholders has to be taken into account while framing the dividend policy.
(iii) Tax Considerations for Shareholders:
Efforts should be made to make the company’s shares more attractive from the tax point of view. This refers to the difference between capital gains tax rate and income tax rate on current income. Shareholders of high income group do not like cash dividends as much as they like share-dividend or no dividend. In other words, if a company has a large percentage of wealthy shareholders who are in the high income tax bracket, the company may pay out a lower percentage of its earnings as dividends.
It implies that the company should chalk out a tax oriented dividend policy under which- (a) shareholders do not receive dividends and get most income by way of capital gains (when they sell the share) or (b) bonus shares are issued in lieu of cash dividends or (c) classified dividends are used.
On the other hand, if the majority of the company’s shareholders are in the low income tax bracket, they would prefer regular dividends to capital gains.
2. Company-Oriented Factors:
Against the financial requirements, a dividend policy based on company’s best interest and its requirements need not be against the shareholders’ interests.
However, due to problems in making proper diagnosis of shareholders’ interests and also easy to identify the company’s own interests, companies often follow such dividend policies which attach prime significance to company’s interests and offer secondary importance to shareholders’ interests.
The following factors affect the company’s interest-oriented dividend policy:
(i) Legal or Contractual Restrictions / Constraints:
This is a very important factor to be taken into account while chalking out the dividend policy. A dividend policy has to be framed out within the statutory provisions relating to dividends. Such legal provisions may be related to divisible profit, highest and lowest limits of dividend, methods, of payments, etc.
With reference to Indian conditions, we have legal restrictions provided in the Companies Act, 2013. Besides the provisions of the Companies Act, Memorandum and Articles of Association also prescribe certain limitations and restrictions, which must be taken into account while chalking out dividend policy.
The contract between the company and its creditors or between company and its preference shareholders may include restraints on the company’s freedom to declare dividends and other activities for the protection of lenders’ or preference shareholders’ investments.
(ii) Liquidity, Credit Standing and Working Capital Requirements:
Payment of dividend reduces the working capital availability and therefore, dividend policy should be designed after taking into account the availability of cash as well as the impact of dividend payments on working capital. Liquidity should also be considered. When a regular dividend policy has been formulated and date of dividend payment is to be made when cash is in shortage, one can question the importance of regular dividend policy; is it wise to pay dividend by borrowings from the bank or is it wise to pay dividend at the cost of liquidity.
If the dividend has to be paid by borrowings from the bank, it is not desirable because this act may lead to weak financial position of the company. Similarly, if the regular dividend reduces the working capital and/or hampers the liquidity, then not only whole capital structure of the company becomes defective but also both the creditors and investors may demand for the rise in the price of their funds. In such a case, shareholders’ interest might be in danger.
(iii) Need for Expansion—Immediate or Future:
When a company earns profit continuously over a period of time, it thinks about expansion/improvement. Such an expansion programme may be executed either by expanding the existing activities or by introducing new activities. In each case additional fund is required. This additional fund can be obtained from different sources, of which retained earnings is the most important.
Thus, there is a tendency to pay fewer dividends and retain more for financing the expansion programmes. However, the company has to take into account in such a case the cost of dividend distribution and the cost of retained earnings. This is how does expansion programme affect the dividend decisions.
(iv) Business Cycle:
The profits of few companies fluctuate in accordance with business cycle. It is, therefore, required that adequate efforts should be made to keep the uniformity in dividends payable year-to-year. This can be possible only when a portion of profits earned during boom period is retained for depression period, so that dividend uniformity could be maintained even in depression phase of cycle, when profits are likely to be low.
(v) Dividend Policies and Shareholders’ Relationship:
Like individuals, companies also become the blind follower of traditions. Once a dividend policy is adopted, any attempt to change it becomes controversial and questionable. Thus, in many cases, dividend policies result from tradition, ignorance and indifference rather than from any logical considerations. In such a case dividend policy set up earlier becomes a standard or convention which must be adopted by that company or even industry.
(vi) Availability of External Capital:
If a company has a firm belief that necessary funds for future development programmes could be availed from the external sources, this must be taken into consideration while framing the dividend policy. Past Dividend policies do have deep impact on future share issues and/or debt-capital market. It has been experienced that a company having sound dividend policy has invariably found good market for its shares. On the other hand, a company regularly distributing the whole of earned profits has some kind of difficulty in raising debt capital.
Inflation also affects the dividend policies. Funds generated through depreciation for replacing the fixed assets may not be adequate/may become short due to price rise, i.e., inflation. In such a situation the company has to depend upon retained earnings to make up the shortage.
Undoubtedly, the dividend pay-out ratio would tend to be low. Again, in the period of inflation the accounting profits are likely to be over-stated. If higher pay-out ratio is offered, this will eventually lead to capital erosion and might result into liquidation. As such, inflation factor is also to be considered, while designing the dividend policy.
3. Other Factors:
Besides the ownership factors and company-oriented factors there are few more general factors which affect the dividend policy.
(i) Nature of Business:
A most important determinant of dividend policy of a company is its nature of business. It is a well-established fact that the nature of business has far reaching impact on the volume and stability of earnings. Consumer good industry normally suffers less from uncertainties of earnings and therefore, companies in this industry pay dividends with more regularity.
But this policy may not be feasible in the case of capital goods industry. Industries with stable and steady earnings are in a position to formulate consistent dividend policies. Generally speaking, large and matured companies pay reasonably good but not an excessive rate of dividend.
A healthy company with an eye on future follows somewhat a cautious policy and tries to build up reserves. A company which believes in publicity gimmicks may follow a more liberal dividend policy to its future loss. All these examples indicate that the nature of business has serious impact on dividend policy formulation.
(ii) Attitudes and Objectives of Management:
Whereas some companies may be very liberal in dividend payments, some others may be stingy and miser. However, a large number of companies may be found within these two extremes. Niggardly companies wish to conserve the cash. Though such policy may easily meet the future needs funds, it deprives the shareholders of a legitimate return on their investments. On the other hand, liberal companies feel that shareholders are entitled to an established rate of dividend as long as their financial position is reasonably sound.
The attitude of the management affects the dividend policies of companies in another way also. The shareholders, who control the management of the company, may be interested to create their own ’empire’. They may consider the retained earnings and its reinvestment in the business as more powerful technique for achieving their objective of ’empire-building’, and making their company as the largest in the field.
(iii) Composition of Shareholding:
The variations in the composition of shareholding may account for marked variations in the dividend policies. If the ownership of the company is only in few hands i.e., closely-held company, the personal objectives of the directors and of a majority of shareholders may govern the dividend decisions.
A rigid dividend policy may be adopted for internal growth by such a company. If the company’s ownership is in the hands of large number of shareholders widely scattered and with varied preferences and wishes, i.e., widely-held company, they may compel the company to follow a liberal dividend policy. Dividend policies are also greatly affected by the tax-related-status of these shareholders and also their views regarding tax matters.
For example, a closely-held company is likely to pay-out relatively low dividend to its few shareholders in the high income tax brackets. On the other hand, shareholders of widely-held company may be interested in high dividend pay-out. It is to be recollected that with the abolition of dividend tax in India, tax factor has become irrelevant for dividend policy.
(iv) Restriction by Financial Institutions:
Sometimes financial institutions which provide long-term loans to companies put a clause restricting dividend payment till the loan as a whole or a substantial part of it is repaid.
(v) Age of the Company:
Age of the company also affects the dividend policies. Newly established companies are normally not in a position to pay proper amount of dividend during few initial years. Since such companies have to depend on retained earnings for few years, they follow a very rigid dividend policy in the beginning. On the other hand, old companies may pursue liberal dividend policy because they can easily distribute higher dividend out of higher earnings without disturbing the financial position.
(vi) Corporate Tax Policy:
Corporate tax policy of the Govt, also affects the dividend policies. Sometimes Govt provides incentives and concessions through tax policy for speeding up the rate of capital formation; such incentives are made available to those companies who create reserves out of profits. Attitude towards more retention of profits is encouraged by imposing additional tax on companies paying higher amount of dividend.
(vii) Public Opinion:
Public opinion and public reactions also affect the company’s dividend policy. It has been observed that companies distributing higher dividend amounts become the topics of discussion in few areas and consequently employees start demanding pay-hike and bonus increase, while consumers start demanding reduction in prices of goods and products.