OVERVIEW Dividends should fulfill the objectives of both the stockholders and company.
Policies: The more stable a company`s earnings, the more regular its issuance of dividends. However, if cash flow and investment requirements are volatile, the company should avoid establishing a high regular dividend. If dividends are increased, they should continue at the higher rate since stockholders will expect them to do so.
Reasons dividend policy is important:
- Affects investor attitudes. Stockholders usually look negatively on a company that cuts its dividends.
- Impacts the company`s financing program and capital budget.
- Affects the company`s cash position. A company with liquidity problems may have to restrict or cease dividend payments.
Factors that influence dividend policy:
• Net income: A higher net income allows for more dividends.
• Earnings stability: A stable earnings usually result in more dividends.
• Growth rate: A rapidly growing company often restricts dividends in order to retain funds in the business to promote further growth.
• Debt position: A highly leveraged business is more likely to retain earnings to satisfy principal and interest payments on debt.
• Loan restrictions: Dividends may be restricted in accordance with a loan agreement.
• lnternal financing: A company that wants to finance its operations internally will retain greater earnings. Internal financing is the least costly financing source.
• Ability to finance externally: A company with easy access to the capital markets can afford a higher dividend payout.
• Maturity and size: A mature, large company has easier access to outside financing and has less need to retain profits.
• Taxes: Tax penalties may be assessed for excess accumulated retained earnings.
Types of dividend policies:
- Stable dividends-per-share policy: This policy is typically looked on favorably by investors. Dividend stability implies a low-risk company. Some financial institutions and private investors invest only in companies with stable dividends, and individuals relying on a fixed income also favor stable dividends.
- Compromise policy: A compromise between policies 1 and 2 may be suitable for a company. Example: A company pays a low dollar amount per share plus a percentage increment in good years. The increment should not be paid regularly because stockholders come to expect it. This policy may be advisable when profitability shows wide variation.
- Residual-dividend policy: If a firm`s investment opportunities are unstable, the company may opt for a fluctuating dividend policy in which the amount of earnings retained depends on the availability of investment opportunities in a given year.
- Constant dividend-payout-ratio (dividends per share/earnings per share) policy: A constant percentage of earnings is paid out in dividends. Since net income varies, the dividends also vary. Most stockholders do not like fluctuation in dividends.
Theoretical position: Theoretically a company should retain earnings rather than distribute them when the corporate return exceeds the return investors can obtain on their money elsewhere.
- If the company`s return on profits exceeds the cost of capital, market price of stock will rise. However, practically speaking, investors will expect to receive dividends.