Financial and Strategic Management

What is a Dividend Policy?

Dividend policy determines what portion of earnings will be paid out to stockholders and what portion will be retained in the business to finance long-term growth. Dividend constitutes the cash flow that accrues to equity holders whereas retained earnings are one of the most significant sources of funds for financing corporate growth. Both dividend and growth are desirable but are conflicting goals to each other. A higher dividend means less retained earnings and vice versa. This position is quite challenging for the finance manager and necessitates the need to establish a dividend policy in the firm which will evolve a pattern of dividend payments having no adverse effects on future actions of the firm.

The dividend is the part of EAT (Earnings after taxes) which is paid to the shareholders. There is no stipulation in the legislation about the dividend policy of an organization. The dividend policy of an organization depends on multiple factors. A finance manager should be aware of the different aspects affecting the dividend policy of an organization

The formulation of the dividend policy poses many problems. On the one hand, the theory would seem to dictate that the firm should retain all funds which can be employed at a higher rate than the capitalization rate; on the other hand, stock-holders preference must be considered.

Two important considerations evolve from the above, firstly, whether owners’ needs are more important than the needs of the firm. It is not easy to ascertain the extent to which shareholders best interest or desires affect dividend policy because of the following difficulties: (1) in determining the dividend ‘needs of the stock-holders, as related to tax position, capital gains, current incomes; it is also difficult to locate exactly what more affects the interest of the shareholder’s current income requirements or alternative use of funds or tax considerations. (2) Existing conflict of interest amongst shareholders dividend policy may be advantageous to one and not to others. Nevertheless, investor’s expectations of dividends are mainly based on three factors viz., (a) reduction of uncertainty due to current earnings by way of dividend. (b) Indication of the company’s strength and sound position that responses to confidence in investors. (c) To meet the need for current income.

Secondly, the needs of the firm are easier to determine which the center of attention is for the policymakers. Firmoriented matters relating to dividend policy can be grouped under the following six categories, affecting directly or indirectly the determination and the appropriateness of the policy:

  1. Firms’ contractual obligations, restrictions in loan agreement and/or legal limitations/considerations; and insufficiency of cash to pay dividends.
  2. Liquidity, credit standing, and working capital requirement and considerations. Ability to borrow, nature of stockholders, degree of control, the timing of investment opportunities, inflation, and need to repay debt.
  3. Need for expansion-availability of external finance, the financial position of promoters, the relative cost of external funds, the ratio of debt to equity.
  4. Business cycle considerations.
  5. Factors relating to future financing.
  6. Past dividend policies and stockholder’s relationship.

About the author

Shreya Kushwaha

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