Factors determining dividend policy, Financial Management

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Q. Factors Determining Dividend Policy?

(1) Financial Needs of the Firm: - Financial requirement of a firm are directly related to the investment opportunities available to it.

  • If a firm has plentiful profitable investment opportunities it will adopt a policy of distributing lower dividends.
  • Alternatively if the firm has little or no investment opportunities it must retain only a small portion of its earnings and must distribute the rest as dividends.

(2) Stability of Dividends: - Investors forever prefer a stable dividend policy. They expect that they must get a fixed amount as dividends which should increase gradually over the years.

(3) Legal Restrictions: - The firm's dividend policy has to be originated within the legal provisions and restrictions. For example section 205 of the Indian Companies Act provides that dividend shall be paid merely out of the current profits or past profits after providing for depreciation.

(4) Restrictions in Loan Agreement: - Lenders mainly the financial institutions put certain restrictions on payment of dividend to safeguard their interests. The subsequent restrictions may be:

  • A loan agreement may perhaps prohibit the payment of any dividend as long as the firm's current ratio is less than say 2:1
  • A loan agreement may perhaps prohibit the payment of any dividend as long as the firm's Debt-Equity ratio is more than say 1.5:1
  • They may perhaps prohibit the payment of dividends in excess of a certain percentage say 10%.

When such restrictions are place the company will have to keep a low dividend payout ratio.

(5) Liquidity: - Payment of dividend causes adequate outflow of cash. Although a firm may have adequate profits it mayn't have enough cash to pay the dividends. Therefore the cash position is a significant factor in determining the size of dividends. Higher the cash as well as overall liquidity position of a firm higher will be its ability to pay the dividends.

(6) Access to Capital Market: - A company which isn't sufficiently liquid can still pay dividends if it has easy accessibility to the capital market. Alternative if a company is able to raise debt or equity in the capital market it will can pay dividends even if its liquid position is not good.

(7) Stability of Earnings: - Stability of earnings as well has a significant effect on the dividend policy of a firm. Usually the greater the stability of earnings greater will be the dividend payout ratio.

(8) Objectives of Maintaining Control: - Occasionally the present management employs dividend policy to retain control of the company in its own hands. When a company reimburses larger dividends its liquidity position adversely affected and it may have to issue new shares to raise funds to finance its investment opportunities. If the existing shareholders don't want purchase the new share, their control over the company will be diluted. Under such situations the management will declare lower dividends and earnings will be retained to finance the investment opportunities.

(9) Effect on Earning per Share: - As discussed previously higher dividend payout ratio affects the liquidity position adversely as well as may necessitate the issue of new equity shares in the near future causing an increase in the number of equity shares and ultimately the earning per share may reduce. Alternatively by keeping a low dividend payout ratio the firm can retain earnings resulting in raise in future earnings and thereby an increase in earning per share.

(10) Firm's Expected Rate of Return: - If the firm's likely rate of return would be less than the rate which could be earned by the shareholders themselves from external investment of their funds the firm must retain smaller part of its earnings and must opt for a higher dividend payout ratio.

(11) Inflation: - Inflation may as well act as a constraint on paying larger dividends. Depreciation is accuses on the original cost of the asset and as a result when there is an raise in price level funds generated from depreciation turn into inadequate to replace the obsolete assets.

Therefore companies will have to retain more of its earnings to provide funds to replace the assets as well as hence their dividend payout ratio will be low during periods of inflation.

(12) General State of Economy: - Earnings of a firm are subject to universal economic conditions of the country. If the future economic circumstances are uncertain it may lead to retention of larger part of the earnings of a firm to absorb any eventuality. Similarly in the event of depression when the level of business activity is extremely low the management may reduce the dividend payout ratio of preserve its liquidity position.

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