Some of the factors affecting dividend policy of a firm or company or business are as follows:
1. Stability of Earnings 2. Financing Policy of the Company 3. Liquidity of Funds 4. Dividend 5. Policy of Competitive Concerns 6. Past Dividend Rates 7. Debt Obligations 8. Ability to Borrow 9. Growth Needs of the Company;
10. Profit Rate 11. Legal Requirements 12. Policy of Control 13. Corporate Taxation Policy 14. Tax Position of Shareholders 15. Effect of Trade Cycle. And 25 other factors.
Factors Affecting Dividend Policy of a Firm, Business and Company: External and Internal Factors
Factors Affecting Dividend Policy – List of Major Factors which Influence Dividend Policy of a Company
We give here a list of major factors which influence dividend policy of a company:
1. Stability of Earnings:
Stability of earnings is one of the important factors influencing the dividend policy. If earnings are relatively stable, a firm is in a better position to predict what its future earnings will be and such companies are more likely to pay out a higher percentage of its earnings in dividends than a concern which has a fluctuating earnings.
Generally, the concerns which deal in necessities suffer less from fluctuating incomes than those concern which deal with fancy or luxurious goods.
2. Financing Policy of the Company:
Dividend policy may be affected and influenced by financing policy of the company. If the company decides to meet its expenses from its earnings, then it will have to pay less dividend to shareholders. On the other hand, if the company feels, that outside borrowing is cheaper than internal financing, then it may decide to pay higher rate of dividend to its shareholder. Thus, the internal financing policy of the company influences the dividend policy of the business firm.
3. Liquidity of Funds:
The liquidity of funds is an important consideration in dividend decisions. According to Guthmann and Dougall, although it is customary to speak of paying dividends ‘out of profits’, a cash dividend only be paid from money in the bank. The presence of profit is an accounting phenomenon and a common legal requirement, with the -cash and working capital position is also necessary in order to judge the ability of the corporation to pay a cash dividend.
Payment of dividend means, a cash outflow, and hence, the greater the cash position and liquidity of the firm is determined by the firm’s investment and financing decisions. While the investment decisions determine the rate of asset expansion and the firm’s needs for funds, the financing decisions determine the manner of financing.
4. Dividend, Policy of Competitive Concerns:
Another factor which influences, is the dividend policy of other competitive concerns in the market. If the other competing concerns, are paying higher rate of dividend than this concern, the shareholders may prefer to invest their money in those concerns rather than in this concern. Hence, every company will have to decide its dividend policy, by keeping in view the dividend policy of other competitive concerns in the market.
5. Past Dividend Rates:
If the firm is already existing, the dividend rate may be decided on the basis of dividends declared in the previous years. It is better for the concern to maintain stability in the rate of dividend and hence, generally the directors will have to keep in mind the rate of dividend declared in the past.
6. Debt Obligations:
A firm which has incurred heavy indebtedness, is not in a position to pay higher dividends to shareholders. Earning retention is very important for such concerns which are following a programme of substantial debt reduction. On the other hand, if the company has no debt obligations, it can afford to pay higher rate of dividend.
7. Ability to Borrow:
Every company requires finance both for expansion programmes as well as for meeting unanticipated expenses. Hence, the companies have to borrow from the market, well established and large firms have better access to the capital market than new and small, firms and hence, they can pay higher rate of dividend. The new companies generally find it difficult to borrow from the market and hence they cannot afford to pay higher rate of dividend.
8. Growth Needs of the Company:
Another factor which influences the rate of dividend is the growth needs of the company. In case the company has already expanded considerably, it does not require funds for further expansions. On the other hand, if the company has expansion programmes, it would need more money for growth and development. Thus when money for expansion is not, needed, then it is easy for the company to declare higher rate of dividend.
9. Profit Rate:
Another important consideration for deciding the dividend is the profit rate of the firm. The internal profitability rate of the firm provides a basis for comparing the productivity of retained earnings to the alternative return which could be earned elsewhere. Thus, alternative investment opportunities also play an important role in dividend decisions.
10. Legal Requirements:
While declaring dividend, the board of directors will have to consider the legal restriction. The Indian Companies Act, 1956, prescribes certain guidelines in respect of declaration and payment of dividends and they are to be strictly observed by the company for declaring dividends.
11. Policy of Control:
Policy of control is another important factor which influences dividend policy. If the company feels that no new shareholders should be added, then it will have to pay less dividends. Generally, it is felt, that new shareholders, can dilute the existing control of the management over the concern. Hence, if maintenance of existing control is an important consideration, the rate of dividend may be lower so that the company can meet its financial requirements from its retained earnings without issuing additional shares to the public.
12. Corporate Taxation Policy:
Corporate taxes affect the rate of dividends of the concern. High rates of taxation reduce the residual profits available for distribution to shareholders. Hence, the rate of dividend is affected. Further, in some circumstances, government puts dividend tax on distribution of dividends beyond a certain limit. This may also affect rate of dividend of the concern.
13. Tax Position of Shareholders:
The tax position of shareholders is another influencing factor on dividend decisions. In a company if a large number of shareholders have already high income from other sources and are bracketed in high income structure, they will not be interested in high dividends because the large part of the dividend income will go away by way of income tax. Hence, they prefer capital gains to cash gains, i.e., dividend capital gains here we mean capital benefit derived by the capitalisation of the reserves or issue of bonus shares.
Instead of receiving the dividend in the form of cash (whatever may be the per cent), the shareholders would like to get shares and increase their holding in the form of shares. This has certain benefits to shareholders. They get money by selling these extra shares received in proportion to their original shareholding.
This will be a capital gain for them. Of course, they have to pay tax on capital gains. But the capital gains tax will be less compared to the income-tax that they should have paid when cash dividend was declared and added to the personal income of the shareholders.
14. Effect of Trade Cycle:
Trade cycle also influences the dividend policy of the concern. For example, during the period of inflation, funds generated from depreciation may not be adequate to replace the assets. Consequently there is a need for retained earnings in order to preserve the earning power of the firm.
15. Attitude of the Interested Group:
A concern may have certain group of interested and powerful shareholders. These people have certain attitude towards payment of dividend and have a definite say in policy formulation regarding dividend payments. If they are not interested in higher rate of dividend, shareholders are not likely to get that. On the other hand, if they are interested in higher rate of dividend, they will manage to make company declare higher rate of dividend even in the face of many odds.
Factors Affecting Dividend Policy – Various Factors that have a Bearing on the Dividend Policy
Maximisation of owners’ wealth is the objective of the financial manager’s job. Whatever decision he/she makes, whether it is investment decision, financing decision or dividend decision, he/she has to maximise value of the firm. There is a positive relation between dividend policy of a firm and value of that firm that is payment of dividends affects the value (increases) of the firm.
Dividend policy means formation of policy by the company regarding the payment of dividend from profits to ordinary shareholders year to year. It determines the ratio between dividend and retained earnings. Then what type of dividend policy do firms adopt?
Whether it is 20 per cent, or 40 per cent or 80 per cent or any other percentage of earnings available to shareholders. The two important dimensions of dividend policy are- what should be the dividend payout ratio? How stable should the dividends be over time?
The policy relating to dividend payout ratio and earnings retention varies not only from industry to industry but also among companies within a given industry and within a company from time to time. These variations are because of factors influencing/affecting dividend policy. But financial executives have to make a balanced-judgment between the financial needs of the company and desires of the shareholders.
In other words, financial executives have to determine optimum dividend policy that should strike the balance between current dividends and future growth which maximises the price of the firm’s shares. The dividend payout ratio of a firm should be determined with reference to two objectives – one maximisation of shareholders’ wealth and second providing sufficient funds to finance growth.
The following are the various factors that have a bearing on the dividend policy:
Factor # 1. Nature of Earnings:
The nature of business has an important bearing on the dividend policy. The industrial units that are having stability of earnings may formulate (adopt) stable or a more consistent dividend policy than other that are having variations in earnings, because they can predict easily their earnings.
Firms that are involved in necessities suffer less from stable incomes than the firms that are involved in luxury goods. The industries/firms that are having stable earnings can adopt stable or high dividend policy, while the other firms that are having variations in earnings should follow a variable or low dividend policy.
Factor # 2. Age of Company:
The age of company has more impact on distribution of profits as dividends. A newly started and growing company may require much of its earnings for financing expansion programms or growth requirements and it may follow rigid dividend policy, wherein most of the earnings are retained.
On the other hand, an old company with good track record and good name in the public can formulate a clear cut and more consistent dividend policy. This type of companies may even pay 100 per cent dividend payout ratio and the required amount for growth can be raised from public.
Factor # 3. Liquidity Position of Company:
Generally, dividends are paid in the form of cash, hence it entails cash. Although, a firm may have sufficient profits to declare dividends, it may not have sufficient cash to pay dividends. Thus, availability of cash and sound financial position of the firm are an important factor in taking dividend decision.
The liquidity of a company depends very much on the investment and financial decisions of a firm, while in turn determining the rate of expansion and the manner of financing. If cash position of a firm is weak, stock dividend will be better and if cash position is good it can go for payment of dividend by cash.
Factor # 4. Equity Shareholders Preference for Current Income:
Legally, the Board of Directors has discretion to decide the distribution of the earnings of a firm. The shareholders who are legal owners of the firm appoint the (BODs). Hence, directors have to take into consideration owners’ preferences, while deciding dividend payment. Shareholders’ preference for current dividends or capital gains depends on their economic status and the effect of tax differential on dividends and capital gains.
When shareholders have more preference in current dividend than capital gains, the firm may require to follow liberal dividend policy. On the other hand, if shareholders prefer capital gains (it may be due to tax or economically sound) than the current dividend then the firm may require to retain more earnings.
Factor # 5. Requirements of Institutional Investors:
Institutional investors like LICs, GICs and Mutual funds (UTI), have an investment policy, which says that these type of institutes have to invest only in companies that have a continuous dividend payment record with stability. They purchase large blocks of shares relatively retail investors to hold or retain for a long period of time. Hence, they represent a significant force in the financial markets, and their demand for company’s securities may increase share price and thereby owners’ wealth.
To attract institutional investors firms may require to follow a stable dividend policy. Apart from theoretical postulates for the desirability of stable dividends, there are also many empirical studies, classic among them being that of Limner, to support the viewpoint that companies pursue a stable dividend policy. Most firms are in favour of stable dividend per share but they are very careful not to raise dividends per share to a level that can safely be sustained in the future.
This cautious creep up of dividends per share results in stable dividend per share pattern during fluctuating earnings per share periods, and a rising step function pattern of dividends per share during increasing earnings per share periods.
Factor # 6. Legal Rules:
Legal rules are significant as they provide framework within which dividend policy is formulated. In other words, dividend policy of a firm has to be evolved within the legal framework and rules and regulations. The legal rules have to do with capital impairment rule, net profits and insolvency rule.
i. Capital Impairment Rule:
First these provisions require that the dividend can be paid from earnings either from current year earnings or from past years’ earnings and reflected in the earned surplus. If firm pays dividend out of capital that adversely affects the security of its lenders. The purpose of this rule is to protect creditors (preference shareholders and auditors of the firm) by providing sufficient equity base because they have originally relied on that base. Therefore, the financial manager should keep in mind the legal rules while declaring dividends.
ii. Net Profits:
This rule is essentially a result of the earlier rule. A firm can pay cash dividends within the limits of current profits plus accumulated balance of retained earnings. According to Sec. 205 of the Companies Act, 1956 provides that dividends shall be declared or paid only from current profits or past profits after recovery of depreciation.
But Central Govt, is empowered to allow (only in public interest) any company to pay dividends for any financial year out of profits of the company without providing depreciation. A firm can take profits of past years if the current year’s profits are not sufficient to maintain stable dividend policy.
If there are any losses that are carried forward, they should be set off from the current year’s earnings before declaration of dividends. So financial manager within the boundaries, at the same time, he has to consider many financial variables and constraints in deciding the amount that is paid as dividends.
iii. Insolvency Rule:
A firm is said to be insolvent in two cases. One, in a legal sense, the recorded value of liabilities exceeding the recorded value of assets, or second, as in a technical sense, as the firm’s inability to pay its creditors as obligations come due. If the firm is insolvent in either sense, it is prohibited from the payment of dividends. The rationale of this rule is to protect the creditors.
Factor # 7. Contractual Requirements:
Generally, lenders may put conditions in a bond indenture or loan agreement which often includes a restriction on the payment of dividend. This is done to protect their interests when the firm is experiencing low liquidity or profitability.
The restrictions may be in three forms:
Firstly, firms may be prohibited from paying dividends in excess of a certain percentage say 10 per cent.
Secondly, a ceiling in terms of net profits that may be used for dividend payment may be laid down. Say only 50 per cent of net profits or a given absolute amount of net profits can be paid as dividends.
Finally, dividends may be restricted by insisting upon a minimum of earnings to be retained. Re-investment reduces debt-equity ratio, which enhances the margin of pillow for the lenders. Therefore, keeping in mind all the restrictions of lenders dividend declaration should be done.
Factor # 8. Financial Needs of the Company:
This is one of the key factors, which influence the dividend policy of a firm. Financial needs means funds required for foreseeable future investment. The required funds may be determined with the help of long-term financial forecasts. A firm that has sufficient profitable investment opportunities, it should follow low dividend payout ratio.
On the other hand, a firm that has no profitable investment opportunity or few investment opportunities adopts high dividend payout ratio (that low retention) because owners’ can reinvest dividends elsewhere at higher rate of return than the firm can do and nominal retention of profit is required to replace and modernise firm’s assets.
Factor # 9. Access to the Capital Market (External Sources):
Access to the capital market means the firm’s ability to raise funds from the capital market. A company, which has easy access to the capital market, provides flexibility in deciding dividend policy.
Easy access to capital market is possible only when companies are well-established and hence, have a profit track record. Generally, dividend policy and investment decisions are interrelated, but in this situation they are independent. The management may tempt to declare a high rate of dividend that attracts investors and maintain existing shareholders.
On the other hand, a firm that has difficulty in accessing capital market to raise required funds, will not be able to pay more dividends. It has to depend on internal funds, so management should follow a conservative dividend policy by maintaining a low rate of dividend and plough back a sizeable portion of profits to face any contingency.
Likewise, the term lending financial institutions advance loans on stiffer terms, it may be desirable to rely on internal sources of financing and accordingly conservative dividend policy should be pursued.
Factor # 10. Control Objective:
Control on the company is also an important factor, which influences dividend policy. When a firm distributes more earnings as dividends in the form of cash it reduces its cash position. As a result, the firm will have to issue shares to the public to raise funds required to finance investment opportunities that leads to loss of control, since, the existing shareholders will have to share control with new owners.
Financing investment projects by way of internal source avoids loss of control. Hence, if the shareholders and management of the firms are reluctant to dilution of control, thus the firm should retain more earnings for investment programmes, by following a conservative dividend policy.
Factor # 11. Inflation:
Inflation is the state of economy in which the prices of products or goods have been increasing. Inflation is a factor that influences dividend policy indirectly. Indian accounting system is based on historical costs.
The funds accumulated from depreciation may not be sufficient to replace the outdated asset or equipment, since depreciation is provided based on historical costs. Consequently, to replace assets and equipment, firm has to depend upon retained earnings, this leads to the payment of low dividend, during inflation period.
Factor # 12. Dividend Policy of Competitors:
Keeping one eye on the competitors’ dividend policy is very important. If the firm wants to retain the existing shareholders or it wants to maintain share price in the market, and if it is planning to raise funds from the public for expansion programmes, it has to pay dividends on par with competitors. Hence, it is one of the factors that influence dividend policy of a firm.
Factor # 13. Past Dividend Rates of the Company:
This is the factor that influences the dividend policy of an existing company (that has already paid dividends). Owners and prospective investors prefer stability in dividends. Generally, firms’ tries to maintain stability in dividends that is based on past dividend rates of the company. Hence, directors will have to keep in mind the past dividend rates while declaring dividends.
Factor # 14. Others:
Apart from the above there are some other factors, which influence dividend policy of a firm, such as trade cycles, corporate taxation policy, and attitude of investors group and repayment of loan.
Factors Affecting Dividend Policy – Top 12 Factors that affect the Dividend Policy of a Firm
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 earnings 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 should 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 the 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 assets.
4. Restrictions in Loan Agreements:
Lenders, mostly the financial institutions, put certain restrictions on the payment of dividend to safeguard their interests. For instance, a loan agreement may prohibit the payment of any dividend as long as the firm’s current ratio is less than, say, 2 : 1 or debt-equity ratio is more than, say 1.5 : 1. They may allow the payment of dividend only when some minimum amount has been transferred to a sinking fund established for the redemption of their debt.
Likewise, they may prohibit the payment of dividends in excess of a certain percentage, say, 10%. Alternatively, they may fix the maximum 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 assets or payment of its liabilities. This situation is common for growing firms which need 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 easy accessibility to the 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 also 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. The reason is, that such firms are more confident of maintaining the higher dividends from year to year. For instance, the earnings of public utility companies are relatively stable and hence their dividend payout ratio is usually high.
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, 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 earnings 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, the 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 increase in price level, funds generated from depreciation become inadequate to replace the obsolete assets. 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 country. 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 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.
Factors Influencing Dividend Policy – Top 12 important Factors that Influence the Dividend Policy
Many factors influence a company in its dividend policy.
The following are some of the important factors, which influence dividend policy of a concern:
1. Stability of Earnings:
One of the important factors, which influence the dividend policy of a concern, is stability of earnings. If the earnings are relatively stable then a concern can easily predict its future earnings and such a company is more likely to pay out a higher percentage of its profits as dividends than a company, which has unstable earnings.
2. Financial Policy of the Company:
Dividend policy may be influenced by financial policy of the company. If the company decides to meet its expenses from retained earnings then it will have to pay fewer dividends to shareholders. On the other hand, if the company feels that outside borrowings are cheaper than its own funds, then it may decide to pay higher rate of dividends to its shareholders.
3. Liquidity of Funds:
The liquidity of funds, is an important consideration in dividend decisions. The greater the cash position and liquidity of the firm, the greater is the ability to pay dividend and vice versa.
4. Ability to Borrow:
The well-established firms have better access to the capital markets and they can borrow any amount of capital without any difficulty. Such firms can pay high rate of dividends. A new company which is unfamiliar may find it difficult to borrow money from the market and hence such firms cannot afford to pay high rate of dividend.
5. Growth Needs of the Company:
If the company is sufficiently expanded and has no intension to take up any further expansion programmes in near future such companies can afford to pay high rate of dividends. On the other hand, if the company is intended to take up further expansion programmes, it needs more money for further growth and development. Hence cannot afford to pay higher rate of dividends.
6. Profit Rate:
The profit margin is one of the important criteria for dividend decision. The rate of profit and the rate of dividend are directly related. Higher the rate of profit greater will be the rate of dividend and vice versa.
7. Legal Requirements:
While declaring the dividends, the board of directors must see the legal provisions of the company’s Act, 1956 regarding the dividend policy.
8. Policy of Control:
If the company feels that no new shareholder should enter the company then such companies usually go for bonus issue of shares to the existing shareholders in lieu of issuing shares to the general public. On the other hand, if the company has no objection in inviting the general public to subscribe for shares, then the companies may go for fresh issue of shares to the general public and may pay high rate of dividend to shareholders.
9. Corporate Taxation Policy:
Corporate tax refers to the income tax payable by the corporate sector on profits to the government. The corporate tax rate and the rate of dividend are inversely related. A heavy rate of taxation reduces the profits available for distribution and hence, the rate of dividend is less. On the other hand, a low rate of corporate tax increases the profit available for distribution and hence the rate of dividend will be high.
10. Tax Position of Shareholders:
The tax position of shareholders is another influencing factor on dividend decision. If majority of the shareholders belong to high income group, they may not like to receive cash dividend. Hence they may prefer capital gain rather than cash gain.
11. Effects of Trade Cycle:
The trade cycle is also one of the factors that influence the dividend policy of a concern. During prosperity stage the funds generated from depreciation may not be adequate to replace the assets. In such a case there is a need for retained earnings to be used in order to preserve the earning capacity of the firm and hence, the firm cannot afford to pay high rate of dividend and vice versa.
12. Attitude of the Interested Group:
A concern may have certain group of powerful shareholders and these shareholders may have a say in the payment of dividend. If these shareholders are not interested in paying high rate of dividend then the company may declare a low rate of dividend. On the other hand, if they have no objection in paying high rate of dividend then the company may declare a high rate of dividend.
Factors Influencing Dividend Policy/Decisions – Taken by the Board of Directors
Dividend policy aims to provide for a regular and sizeable dividend flow, while allowing the company to maintain the financial flexibility to take advantage of attractive investment opportunities in the future. Dividend affects the mood of the present shareholders; it also influences the behavior and response of prospective investors, stock exchanges and financial institutions because of its relationship with the worth of the company which in turn affects the market value of its shares.
Therefore decision regarding dividend is taken by the Board of Directors is influenced by following factors:
Factor # 1. Legal Constraints:
Payments of dividends to shareholders is bound by certain legal imposition enacted by corporate laws, In India the Companies Act of 1956 provides a legal frame work for payment of dividends.
According to Section 205, dividend shall be declared or paid by a company for any financial year out of the current year profits of the company for that year arrived at after providing for depreciation or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation and remaining undistributed or out of both or out of moneys provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government.
Factor # 2. Requirement of the Shareholders:
Dividends play an important role in rewarding shareholders; dividends have great importance to both the companies that issue them and the shareholders who receive them. Some of this importance is based on tangible results from the distribution of money; a company’s ability to pay dividends is one of the few signs of its financial health.
Usually shareholders expect attractive Returns, Less Volatility, Increased Yield and Favorable Tax Treatment from their investment. Many investors consider dividends as a sign of safety and financial conservatism. If a company is unable to meet these expectations of shareholders they may lose faith on the management and credibility of the company.
Factor # 3. Availability of Liquid Funds:
When company pays dividend its results in outflow of cash and thus the payment of dividend is highly influenced by cash and liquidity position of the firm. Companies with good financial performance and exceptional stable earnings always maintain a good amount of liquid funds on the other hand growth based company spends a lot of funds on expanding activities and permanent working capital and therefore most of the growth oriented companies are not in a position to declare dividends.
Further some companies invest surplus cash in short term investments in order to earn quick profits from idle cash, thus irrespective of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.
Factor # 4. Financial Needs of the Firm:
Most of the companies often require additional funds in order to meet planned and unplanned expenditure and therefore instead of distributing profits to shareholders they conserve profits for meeting the increased requirements of working capital or for future expansion. As a company grows and expands logically, it requires a larger amount of capital.
Thus, organizations which have sufficient possibilities of growth require more capital, while the case is different in respect of companies with less growth prospects. In order to meet the fund requirements one of the alternative is to use profits. Thus some companies distribute dividend at low rates and retain a big part of profits.
Factor # 5. Investment Opportunities:
Investment made in buying financial instruments such as new shares, bonds, securities, etc. is considered as a Financial Investment. Investment made in plant and equipment, land and building and other infrastructure facilities is considered as Real Investment. A company should identify appropriate invest opportunities and invest in them so that it provides the basis for the firm’s earning power and value.
Therefore a company can utilize present and past profits to invest in profitable ventures, However if investment opportunities are inadequate, it is better to pay dividends and raise external funds whenever necessary for such opportunities.
Factor # 6. Economic Conditions:
Most the company’s dividend policies are highly impacted by the economic conditions prevailing in the economy. Economic condition means the state of the economy that is determined by numerous macroeconomic and micro economic factors, including monetary and fiscal policy, the state of the global economy, unemployment levels, productivity, exchange rates, inflation, and business cycles and so on.
Economic conditions are considered to be sound or positive when an economy is expanding, and are considered to be adverse or negative when an economy is contracting.
Therefore if the economy is going through period of recession most the firms face problem of low sales and declining profits and therefore as a precautionary measure may not declare dividends to protect themselves from cash crunch.
Factor # 7. Nature and Size of Business:
The dividend policy is also influenced by the nature and size of its business. Big business organizations require more funds than the small business organization. Further some business type’s needs huge amount of investment in fixed assets and have the lowest needs for current assets.
On the other hand, trading and financial firms have a very low investment in fixed assets but huge amount to be invested in working capital. Therefore depending of business and size dividend policy is framed accordingly.
Factor # 8. Stability of Earnings:
Companies that have a proven business model are profitable and usually have stability in earnings. Stable earnings are important to a business and features strongly in business planning. Therefore if a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.
Relatively stable earnings also allow stable capital investment; often important for productivity growth and it is also measures the ability of a company to maintain the level of dividend paid out. The higher the earnings the better the ability to maintain dividends.
Factor # 9. Desire of Control:
If a firm has equity capital raised by issuing shares to public it may dilute its ownership stake in business. Because equity investors typically have the right to vote on important company decisions, company management can potentially lose control of their business if they sell too much stock.
In this context raising additional through equity will result in lesser dividend per share as profits will be distributed to a large number of shareholders. However additional equity shares will dilute the control of management. Therefore it is important for the management to retain management has 51% of stake in equity capital and also to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.
Factor # 10. Access to the Capital Market:
A firm can finance a given level of investment with debt or equity. In order to procure funds firms have to access capital markets depending on its cash position. A company with good reserves achieved through reducing the dividend payout ratio will have easy access to capital markets in raising additional funds.
It does not require more retained earnings. So a firm’s dividend payment capacity becomes high. On the other hand a firm with limited access to capital markets, it is likely to follow low dividend payout ratio. They are likely to rely more heavily on retained earnings as a source of financing their investments.
Factor # 11. Tax Implications:
Shareholders are primarily concerned with the after-tax returns of their investments, company pays taxes on its earnings prior to any dividend distribution and investors receiving dividends do not pay taxes on dividend income. However higher tax rates can reduce the earnings of companies and at the same time dividend is also lowered down.
In India government also imposes dividend distribution tax as a result of all these shareholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income and opt for capital gains to dividends because capital gains are usually taxed at a lower rate.
Factors Affecting Dividend Policy – Top 7 Factors Affecting the Dividend Policy of a Company
1. Legal Implications:
Over the years, legal statutes have become quite explicit in dealing with corporate dividend policy. Dividends must be paid out of current earnings or from earnings previously accrued as reflected in the retained earnings account.
Today, state laws emphasize three rules for dividend policy:
i. The net profit rule states that dividends must be paid from past or current earnings.
ii. The capital impairment rule prohibits the payment of dividends from the capital account to protect shareholders and creditors.
iii. The insolvency rule states that the corporation may not pay dividends when insolvent. This means that dividends may not be paid when liabilities exceed assets.
The legal rules act as boundaries within which a corporation can operate in terms of paying dividends. Within these boundaries are many financial factors that have an impact on the dividend policy of a firm.
2. Liquidity:
A firm that may be growing and quite profitable may not be able to pay a specified cash dividend because of lack of cash on hand. The net income figure visible on the year-end income statement represents the increase in retained earnings on the balance sheet. To offset the increase in retained earnings, assets will increase in the form of current or possibly fixed assets required to conduct business.
If there is insufficient cash or if there are sufficient pressures for liquidity due to the high growth rate of the firm, management may not be able to declare a cash dividend. The issue is the amount of cash management must have to carry on the daily routine of the business.
3. Restrictions in Loan Agreements:
When a firm borrows money from banks or from individuals through a bond issue, the legal document that accompanies the loan may in many instances have restrictive clauses pertaining to the payment of dividends. The intent of these restrictions is to protect the lender in terms of the firm’s ability to service the debt obligations.
Examples of these restrictions are:
i. The payment of dividends can be made only out of current earnings,
ii. The payment of dividends cannot be made when the ratio of current assets to current liabilities decreases to some level, and
iii. The establishment of a sinking fund is required to guarantee the retirement of debt out of current earnings.
A similar restriction associated with a preferred stock issue is that common stock dividends cannot be paid until all accrued preferred stock dividends have been distributed. These are a few examples of restrictive clauses pertaining to the payment of dividends which affect the dividend policy of the firm.
4. Continued Access to the Capital Market:
A firm that is well established and has a record of profitability will be able to raise debt or equity capital on relatively short notice. A firm that has this ability can pay a cash dividend even though management feels that there will be substantial cash needs in the near future. Ready access to debt and equity financing instruments allows management to feel secure in its ability to pay both the cash dividend and the corporate obligations.
The impact of the cash dividend is, therefore, not as great on the liquidity position of the firm. A smaller firm that does not have quick access to the debt or equity markets probably will not be able to pay the cash dividend if there are foreseeable heavy future cash drains.
5. Rate of Return and Investment Opportunities:
If the firm is growing rapidly, there will be a large demand for capital. When current earnings are a primary source of funds, management may feel that internal expansion and continued growth take precedence over the payment of cash dividends.
This would especially be true if the rate of return the firm earns on its assets is in excess of what the individual shareholder could expect to receive by taking dividends and reinvesting those amounts elsewhere.
6. Control:
With cash being utilized to pay dividends, it may be necessary for a firm to look to the equity market for additional rupees of capital to finance future expansion. Percentage control of the stock becomes an issue when a group of shareholders is unable to purchase a percentage of the new issue to maintain its percentage of ownership of the corporation.
This situation can be of critical importance for the management, which may wish to maintain 51 per cent control but may not be able to if more stock is issued. Under these circumstances, management may withhold the payment of cash dividends in order to retain the necessary funds for investment purposes.
7. Tax Implications for Shareholders:
The tax status of the owners of the corporation will in many cases influence the dividend policy of the firm. In a closely held corporation with owners in the high income tax brackets, little or no dividends, which would be taxed at the normal income tax rate, may be desired. Rather, the owners would prefer to take the income out of the corporation in the form of capital gains, which would be taxed at a much lower rate.
In cases of public corporations where the owners are in a high tax bracket, an immediate conflict will arise due to the fact that these individuals will not want cash dividends, while those in the lower tax brackets will want them.