What is dividend policy? Explain the factors influencing the dividend policy of a company.

 Q. What is dividend policy? Explain the factors influencing the dividend policy of a company. 

Ans. MEANING OF DIVIDED POLICY:

Divided refers to that part of net profits of a company which is distributed among shareholders as a return on their investment in the company. 

A settled approach for the payment of dividend is known as dividend policy. Therefore, dividend policy means the broad approach according to which every year it is determined how much of the net profits are to be distributed as dividend and how much are to be retained in business. Thus, the dividend policy divide the net profits or earnings after taxes into two parts: 

(1) Earnings to be distributed as dividend 

(2) Earnings retained in business 

A firm will have to choose between the portion of profits distributed as dividends and the portion ploughed back into the business. The choice is called dividend policy and it will have its effect on both the long term financing and the wealth of shareholders. 

Factors influencing/determining/affecting the dividend policy.

The following are the factors which generally affect the dividend policy of a firm:

(1) Financial Needs of the Firm: Financial needs of a firm are directly related to the investment opportunities available to it. If a firm has abundant profitable investment opportunities, it will adopt a policy of distributing lower dividends. It would like to retain a large part of its earnings because it can reinvest them at a higher rate than the shareholders can. Other reason for retaining the earning is, that, issuing new share capital is inconvenient as well as involves flotation costs. On the other hand, if the firm has little or no investment opportunities, it should retain only a small portion of its earnings and distribute the rest as dividends.

(2) Stability of Dividends: Investors always prefer a stable dividend policy. They expect that they should get a fixed amount as dividends which should increase gradually over the years. Hence, while determining the dividend policy, the merits of stability of dividends like investor’s desire for current income, resolution of investor’s uncertainty, requirement of institutional investors etc. should be given due consideration.

(3) Legal Restrictions: The firm’s dividend policy has to be formulated within the legal provisions and restrictions. For instance, section 123 of the Indian Companies Act, 2013 provides that dividend shall be paid only out of current profits or past profits after providing for depreciation. Likewise, if there are past accumulated losses, they must be first set off against current year’s profits before the declaration of any dividend. Similarly, a firm is prohibited from declaring any dividends if its liabilities exceed its assests.

(4) Restrictions in Loan Agreements: Lenders, mostly the financial institutions, put certain restrictions on the payment of dividend to safeguard their interests. They may allow the payment of dividend only when some minimum amount has been transferred to sinking fund established for the redemption of their debt. Likewise, they may prohibited the payment of dividends in excess of certain percentage, say, 10%. Alternatively, they may fix the minimum limit of profits that may be used for dividend, say, not more than 40% of the net profits can be paid as dividends. When such restrictions are put, the company will have to keep a low dividend payout ratio.

(5) Liquidity: Payment of dividend causes sufficient outflow of cash. Although a firm may have adequate profits, it may not have enough cash to pay the dividends. It may happen when most of the sales are on credit and firm’s cash resources have been utilized in the expansion of assests or payment of its liabilities. This situation is common for growing firms which needs funds for their expanding activities and permanent working capital. Thus, the cash position is a significant factor in determining the size of dividends. Higher the cash and overall liquidity position of a firm, higher will be its ability to pay dividends. 

(6) Access to Capital Market: A company which is not sufficiently liquid can still pay dividends if it has esay accessibility to capital market. In other words, if a company is able to raise debt or equity in the capital market, it will be able to pay dividends even if its liquid position is not good. While evaluating the ability to raise funds in the capital market, the cost of funds and the promptness with which funds can be raised must be considered. Usually, mature firms have greater access to capital market than the new firms.

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

(8) Objective of Maintaining Control: Sometimes the present management employs dividend policy to retain control of the company in its own hands. When a company pays larger dividends, its liquidity position is adversely affected and it may have to issue new shares to raise funds to finance its investment opportunities. If the existing shareholders do not want or cannot purchase the new shares, their control over the company will be diluted. Under such circumstances, the management will declare lower dividends and earnings will be retained to finance the investment opportunities. 

(9) Effect on Earning per Share: As discussed above (5), high dividend payout ratio affects the liquidity position adversely and 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. On the other hand, by keeping a low dividend payout ratio the firm can retain and plough back larger portion of its earnings resulting in increase in future earnings and thereby an increase in earning per share.

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

(11) Inflation: Inflation may also act as a constraint on paying larger dividends. Depreciation is charged on the original cost of the asset and as a result, when there is an imcrease in price level, funds generated from depreciation become inadequate to replace the obsolete assests. Consequently, companies will have to retain more of its earnings to provide funds to replace the assets and hence their dividend payout ratio will be low during periods of Inflation.

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

All the above factors must be carefully considered before formulating a dividend policy.