What is dividend policy?
Dividend policy is a policy determined by the company to pay out its earnings as a dividend to its shareholders. Determining the part of earnings to be distributed as dividends is a key factor that leads the firm’s stockholders and potential investors to determine the firm’s stock value in the market place. The firm should establish and implement an effective dividend policy that leads the firm to stockholders wealth maximization.
Understanding of Dividend Policy
Dividend policy is concerned with determining the proportion of a firm’s earnings to be distributed in the form of cash dividend and the proportion of earnings to be retained. It is an integral part of the financing decision as it provided internal financing. A firm has three alternatives regarding the distribution of its earnings they are:
- A firm can distribute all of its earnings in the form of cash dividends, or
- It can retain all of its earnings for reinvestment purpose, or
- It can distribute a part of its earnings as dividends and retain the rest earnings for reinvestment purposes.
When dividends are paid to stockholders the firm’s cash is reduced. A firm may decrease its dividend payout and use the retained funds to expand its capacity, to pay off some of its debt or to increase investment. In this way, the firm’s dividend policy is closely related to the firm’s investment and financing decisions.
Determining the part of its earnings to be distributed as dividends to the firm’s shareholders is a key decision that affects the value of the firm’s common stock in the market place. Similarly, the retained earnings are considered to be the most convenient internal source available for financing corporate growth. Thus, every corporate firm should establish and implement an effective dividend policy that leads the firm to stockholders wealth maximization.
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Factors Affecting Dividend Policy
A firm’s dividend policy affected by many factors. The key factors are legal provisions, a firm’s liquidity position, the need to repay debt, restrictions imposed by bondholders, investment opportunities, the stability of earnings, shareholders’ personal tax status, etc.
Also, the main factor of dividend policy is the age of shareholders or types of shareholders. Let us describe it clearly,
Let us assume shareholders age into three groups: A 20-40 years, B 41-60 years, and in group C over 60 years.
Also, suppose the firm regularly earned profit for 5 years and the total profit of it is $ 5,00,000 and not distributed dividends.
In a group, A shareholder’s ages are range from 20 to 30 years. Maybe group A shareholders are not interested to get all earnings of firms as dividends rather than, they force the manager to search the new investment opportunities to earn more profit in the future. Because these shareholders have sufficient time so they search for new investment ways.
In group B shareholders ages are range from 41 to 60 years. Maybe this group of shareholders is more interested in getting the dividend. Also, some shareholders force for dividend distribution or some force for reinvestment.
Last, group C having shareholders ages over the 60 years. Maybe these types of shareholders are interested to get the full amount of profit as dividend. Because they have not sufficient time in their life so they force to distribute the dividend.
Hence, while structuring the dividend policy the manager or CEO must have to meet the satisfaction of its shareholders. Whereas, if shareholders are not satisfied with the company may they can take both legal or illegal actions to get their invested amount.
Also, the manager has arisen issues like whether the company should distribute profit to the shareholders or it should retain it in the company for further investment is an issue. Similarly, issues like how much to retain and how much to distribute and in what form ( cash or stock) to distribute dividends are some other issues.
Dividend Policies types
There are four types of dividend policy behavior which may a firm use or take. They are
A firm’s manager or CEO’s functions are related to dividend decision which relates to the distribution of earnings. All for-profit companies attempt to earn the profit. Once the company earns a profit, it belongs to the shareholders. Though the profit earned by the company belongs to the shareholders, many issues related to its distribution are in the hand of company management. Hence, the financial manager is expected to address all the above-discussed issues in light of the shareholder’s wealth maximization principle.