Financial Management

Factors determining dividend policy of a company

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Dividend Policy

Dividend policy is one of the most significant aspects that attract investors to a firm. It is the choice regarding, out of available earnings how much to retain and how much to compensate the shareholders for their investments and risk they incur. Dividends are usually wanted by shareholders but it is not prudent to distribute all possible earnings considering the unpredictable future and market volatilities.

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 a combination of two or more factors that decide the dividend policy of a company. Let’s have a quick look at them in the following paragraphs:

Liquidity

For paying the dividend, a firm will require access to funds. Even extremely prosperous firms can occasionally have difficulties in paying dividends if the resources are locked up in other types of assets. In summary, firms with higher liquidity pay dividends more frequently than companies with cash locked up in fixed assets or inventory.

Repayment of Debt

Companies having a high load of interest-bearing debts may be hesitant to pay dividends. Dividend payout may be made difficult if the debt is due for repayment. Because paying interest on interest-bearing assets is a necessity in virtually all nations. Shareholders acquire whatever remains after discharging liabilities of debt-holders. It is also conceivable that after paying interest on loans the firm is not left with any distributable earnings. So, such firms would wait until an acceptable level of debt is cleared before they start paying dividends to shareholders. Preference share dividend may be an exception to this idea because their payout is viewed like interest-bearing debt.

Stability of Profits

This is very obvious that constantly profit-making entities are in a better position to pay dividends. Other things staying constant, a firm with steady profitability is more likely to pay out a larger percentage of earnings than a company with variable profits. A firm with shifting patterns in profitability may act conservatively and opt not to pay dividends in anticipation of a potential loss.

Control

The utilisation of retained earnings to finance a new project maintains the company’s ownership and control. This can be useful in businesses where the existing disposition of ownership is of relevance.

Legal Considerations

The legal rules put out parameters within which a business can declare dividends. It is done with a view to safeguarding the interest of creditors, lenders and other persons having a stake in the firm. The court or company law boards can regulate whether or how much dividend can be paid by the firm under consideration.

Inflation

Inflation must be taken into account when a firm establishes its 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 variables such as dividend policies followed by other companies similarly positioned in the sector, management stance on dilution of existing control over the shares, fear of being branded as inept or inefficient, cautious policy versus non-aggressive one.

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