factors affecting dividend policy

Factors Affecting Dividend Policy

Factors Affecting Dividend Policy or Factors Influencing Dividend Policy of a Firm

A firm’s dividend policy is affected by various factors. Some factors affect the amount of dividend and some others affect types of dividend. Factors affecting dividend policy are also called in various ways. Such as determinants of dividend policy, factors influencing dividend policy, factors of dividend policy, etc. but answers are the somehow same for those.

The major factors affecting dividend policy are as follows:

  • Legal Requirements (Legal Provisions)
  • Firm’s Liquidity Position
  • Repayment Need
  • Restrictions Imposed by Bondholders and Preferred Stockholders
  • Investment Opportunities
  • Stability of Earnings
  • Desire for Control
  • Access to the Capital Markets
  • Stockholders Individual Tax Situation

Let’s describe these factors affecting dividend policy individually as follows:

# Legal Requirements (Legal Provisions)

There is no legal compulsion on the part of a company to distribute dividends. However, there are certain conditions imposed by law regarding the way dividend is distributed in the company. Basically, there are three rules relating to dividend payment under the legal requirements,

The net profit rule

The net profit rule states that dividends can be paid out of present or past earnings. It means that the dividends paid can not exceed the sum of current earnings and past accumulated earnings. If there is accumulated loss it must be set off out of the current earnings before paying out any dividends.

The capital impairment rule

The capital impairment rule states that the firm cannot pay a dividend out of its paid-up capital, because it adversely affects the firm’s equity base. The basic idea behind this rule is to protect the claim of creditors by maintaining a sufficient equity base. The dividend payout that impairs capital is considered illegal and directors are personally held responsible for such illegal dividend payment.

Insolvency Rule

If a firm’s liabilities exceed its asset or if it is unable to pay the current obligations, the firm is considered to be financially insolvent. If the firm is insolvent, it is strictly prohibited by law to pay dividends. The basic idea behind this rule is to protect the interest of creditors.

# Firm’s Liquidity Position

The firm’s dividend payout is also affected by the firm’s liquidity position. Having sufficient retained earnings the company prefers to the cash dividend. In spite of sufficient retained earnings, the company may declare a stock dividend instead of a cash dividend.

# Repayment Need

A firm that uses debts must repay it as maturity. The firm has generally two alternatives regarding the repayment of debt: either it can issue alternative securities or it can make provisions out of its earnings. Therefore, if the firm has to retain profits for the purpose of repaying the debt at maturity, the dividend payment capacity of the firm reduces.

# Restrictions Imposed by Bondholders and Preferred Stockholders

Bondholders and preferred stockholders may impose certain restrictions upon the firm regarding dividend payment. For example, the debt contract may prohibit the firm from pay a dividend unless it maintains certain ratios ( like current ratio, times-interest-earned ratio, debt-equity ratio) at the predetermined level. Similarly, the firm may be restricted by its preferred stockholders to pay any dividends on common stock unless the firm pays its entire accrued dividend on preferred stock.

# Investment Opportunities

The amount of dividend payment also depends on investment opportunities available to the company. If a firm has good investment opportunities with a higher expected rate of return than the cost of funds, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividends.

# Stability of Earnings

If a firm has relatively stable earnings it is more likely to pay a relatively large dividend than a firm with relatively fluctuating earnings. The firm with unstable earnings is relatively uncertain about its future earnings so that it prefers to retain more from current earnings.

# Desire for Control

The desire to retain control by the existing management encourages them to retain earnings rather than distributing dividends. It is because issuing new common stocks in the lieu of retained earnings to meet financial needs can dilute the control of existing management. So, if existing management desires to control the management, and firm needs funds for investment, it retains earnings for investment.

# Access to the Capital Markets

A firm with easy access to capital markets retains less and pays more dividend it can easily raise funds from the market whenever the fund is needed. Smaller and newly established firms do not have easy access to the capital market. Therefore, they would have to rely on internal sources of financing. As a result, they prefer not to make larger dividends payment.

# Stockholder’s Individual Tax Situation

The stockholder’s in higher personal tax bracket prefer capital gain rather than cash dividends. It is because the tax rate on the cash dividend is higher than on capital gain.

Conclusion: Factors Affecting Dividend Policy

Hence, these factors affecting dividend policy fluctuate the way of paying dividends in a firm or company. But according to the nature of the firm, from these factors, their level is high and low.

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