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Determinants of Dividend Policy
The payment of dividend involves some legal as well as financial considerations. It is difficult to determine a general dividend policy which can be followed by different firms at different times because dividend decision has to be taken considering the special circumstances of an individual case. The following are important factors which determine dividend policy of a firm:
1. Legal Restrictions: Legal Provisions relating to dividends as laid down in section, 205, 205A, 206 and 207 of companies Act, 1956 are significant because they lay down a framework within which dividend policy is formulated. These provisions require that dividend can be paid only out of current profit or past profits after providing for depreciation. The companies (Transfer of Profits to Reserves) Rules, 1975 require a company providing more than 10% dividend to transfer certain percentage of current year’s profit to Reserves.
When Dividend Proposed
Amount to be transferred to Reserves most not be less than
Exceeds 10% but not 12.5% of paid up capital
2.5% of current year profit
Exceeds 12.5% but not 15% of paid up capital
5% of current year profit
Exceeds 15% but not 20% of paid up capital
7.5% of current year profits
Exceeds 20% of paid up capital
10% of current year profits.
Companies Act, further provides that dividend cannot be paid out of capital, because it will amount to reduction of capital adversely affecting the security of creditors.
2. Desire and Type of Shareholders: Although, legally, the direction as to whether to declare dividend or not has been left with BOD, the directors should give importance to desires of shareholders in declaration of dividends as they are representatives of shareholders. Investors such as retired persons, widows, and other economically weaker persons view dividends as source of funds to meet their day-to-day living expenses. To benefit such investors, the companies should pay regular dividends. On other hand, a wealthy investor in a high income tax bracket may not benefit by high current dividend incomes. Such an investor may be interested in lower current dividend and high capital gains.
3. Nature of Industry: Nature of Industry to which company is engaged also considerably affects dividend policy. Certain industries have comparatively steady and stable demand irrespective of prevailing economic conditions. For example, people used to drink liquor both in boom as well as in recession. Such firms expect regular earnings and hence follow consistent dividend policy. On the other hand, if earnings are uncertain, as in the case of luxury goods conservative policy should be followed. Such firms should retain a substantial part of their current earnings during boom period in order to provide funds to pay adequate dividends in the recession periods. Thus, industries with steady demand of their products can follow a higher dividend payout ratio while cyclical industries should follow a lower payout ratio.
4. Age of Company: It also influences dividend decision of company. A nearly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth while older companies which have established sufficient reserves can afford to pay liberal dividends.
5. Future Financial Requirements: If a company has highly profitable investment opportunities it can convince the shareholders of need for limitation of dividend to increase future earnings and stabilise its financial position. But when profitable investment appointments do not exist then company may not be justified in retaining substantial part of its current earnings. Thus, a concern having few internal investment opportunities should follow high payout ratio as compared to one having more profitable investment opportunities.
6. Liquid Resources: The dividend policy of a firm is also influenced by availability of liquid resources. Although, a firm may have sufficient available profit to declare dividends, yet it may not be desirable to pay dividend if it does not have sufficient liquid resources. Hence liquidity position of company is an important consideration in paying dividends. If company does not have liquid resources, it is better to declare stock dividend i.e. issue of bonus shares to existing shareholders.
7. Requirements of Institutional Investors: Dividend policy of a company can be affected by requirements of institutional investors such as financial institutions, banks, insurance corporations etc. These investors usually favour a policy of regular payment of cash dividends and stipulate there own terms with regard to payment of dividend on equity shares.
8. Stability of Dividends: Stability of dividend refers to payment of dividend regularly and shareholders generally, prefer payment of such regular dividends. Some companies follow a policy of constant dividend per share while others follow a policy of constant payout ratio and while there are some other who follow a policy of constant low dividend per share plus an extra dividend in years of high profits. A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over a number of years or those who have built up sufficient reserves to pay dividends in years of low profits. The policy of constant payout ratio i.e. paying a fixed percentage of net earnings every year may be supported by firm because it is related to firms ability to pay dividends. The policy of constant low dividend per share plus some extra dividend in years of high profits is suitable to firms having fluctuating earnings from year to year.
9. Magnitude and Trend of Earnings: The amount and trend of earnings is an important aspect of dividend policy. It is rather the starting point of the dividend policy. As dividends can be paid only out of present or past’s years profits, earnings of a company fix the upper limits on dividends. The dividends should nearly be paid out of current years earnings only as retained earnings of the previous years become more or less a part of permanent investment in the business to earn current profits. The past trend of the company’s earnings should also be kept in consideration while making dividend decision.
10. Control objectives: When a company pays high dividends out of its earnings, it may result in dilution of both control and earnings for existing shareholders. As in case of high dividend pay out ratio the retained earnings are insignificant and company will have to issue new shares to raise funds to finance its future requirements. The control of the existing shareholders will be diluted if they cannot buy additional shares issued by the company. Similarly issue of new shares shall cause increase in number of equity shares and ultimately cause a lower earnings per share and their price in the market. Thus under these circumstances to maintain control of the existing shareholders, it may be desirable to declare lower dividends and retain earnings to finance the firm’s future requirements.