Financial Management

Factors determining dividend policy of a company

Dividend Policy

Dividend policy is one of the most important factors that attract investors to a company. It the decision about, out of available profits how much to retain and how much to reward the shareholders for their investments and risk they take. Dividends are always desirable by shareholders but it is not wise to distribute all available profits considering the uncertain future and market volatalities.

Different companies pay dividend following own policies and some companies do not pay the dividend at all. For example Microsoft (MSFT). This article discusses some of the very common dividend policies companies take into account before declaring or paying dividends.

Factors determining the dividend policy

There are several factors that could be applicable in individuality or in combination of two or more factors that decide the dividend policy of a company. Let’s have a quick look at them in following paragraphs:

Liquidity

For paying the dividend, a company will require access to cash. Even very profitable companies might sometimes have difficulty in paying dividends if the resources are tied up in other forms of assets. In nutshell, companies with more liquidity pay dividend more frequently than companies having funds tied up in fixed assets or inventories.

Repayment of Debt

Companies with a significant burden of interest-bearing debts may be reluctant to pay dividends. Dividend payout may be made difficult if the debt is scheduled for repayment. Because paying interest on interest-bearing securities is a must in almost all countries. Shareholders get anything remaining after discharging liabilities of debt-holders. It is also possible that after paying interest on debts the company is not left with any distributable profits. So, such companies will wait until a satisfactory level of debt is discharged before they start paying dividends to shareholders. Preference share dividend may be an exception to this notion because their dividend is considered like interest-bearing debt.

Stability of Profits

Other things remaining constant, a company with stable profits is more likely to pay out a higher percentage of earnings than a company with fluctuating profits. A company with fluctuating trends in profitability may act conservatively and decide not to pay dividends in anticipation of a probable loss.

Control

The use of retained earnings to finance a new project preserves the company’s ownership and control. This can be advantageous in firms where the present disposition of shareholding is of importance.

Legal Considerations

The legal provisions lay down boundaries within which a company can declare dividends. It is done with a view to protect the interest of creditors, lenders and other people having stake in the company. The court or company law boards can restrict whether or how much dividend can be paid by the company under consideration.

Inflation

Inflation must be taken into account when a firm establishes it’s dividend policy. This effect has been discussed in models of the dividend.

Likely effect of the declaration and quantum of dividend on market prices.

Other Factors

Tax Considerations, and other factors such as dividend policies adopted by unites similarily placed in the industry, management attitude on dilution of existing control over the shares, fear of being branded as incompetent or inefficient, conservative policy vs non-aggressive one.

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