Factors affecting dividend policy

Dividend decision is the critical decision for the management various factors should be considered while taking dividend decision. Following factors influenced dividend decision directly or indirectly.

a. Legal rules

The legal rules are important in establishing the legal boundaries with in which a firms finalized dividend policy can operate. These rules have to do with capital impairment, insolvency and undue retention of earning

i. Capital impairment rule

Some states define capital as the total par value of the common stock. If a firm’s shareholder’s equity consists of $4million in common stock (at par),$3 million in additional paid-in-capital and $2million in Retained earnings, total capital would be $4million. This company could not pay a cash dividend to tell more than $5million without impairing capital (i.e., reducing shareholders equity before $4 million).

Other states define capital to include not only the total per value of the common a stock But also the additional paid in capital. Under such state states dividends can be paid only to the extent of retained earnings. Notice, we did not say that dividend can be paid “out of retained earnings.” A company pay dividends “out of cash “while incurring a corresponding reduction in the retained earnings account.

ii. Insolvency rule

Some states prohibit the payment of cash dividend if the company is solvent. Insolvency is defined either in a legal sense, as total liabilities of a company exceeding its assets  “at a fair valuation” or,in a” equitable”(technical)sense, as the firm’s inability to pay its creditors as obligation come due. As the firm’s ability to pay its obligations is dependent on its liquidity rather than on its capital, the equitable (technical) solvency restriction gives creditors a good deal of protection. When cash is limited, a company is restricted from favoring  shareholders to the determent of creditors.

iii. Undue retention of earnings rule

The internal revenue code prohibits the undue retention of earnings. Although undue retention is vaguely defined, it is usually though to mean retention significantly in excess of the present and future investment needs of the company. The purpose of the law is to present companies from retained earnings for the sake of avoiding takes.

a. Liquidity position

Profits held as the retained earnings (which show up on the right hand side of the balance sheet) are generally invested in plant and equipment, inventories, and other assets, they are not held as cash. Thus even if a firm has record of earnings, it may not be able to pay cash dividends because of its liquidity position. Indeed, a growing firm, even a very profitable one, typically has a processing need for funds, in such a situation a firm may elect not to pay cash dividends.

b. Need to repay debt

When a firm has issued debt to finance expansion or to substitute for other forms of financing, it is faced with two alternatives. It can refund the debt at maturity by replacing it with another form of security, or it can make provisions for paying off the debt at maturity by replacing it with another form of security, or it can make provisions for paying off the debt. If the decision is to retire the debt, this will generally require the retention of earnings.

c. Restriction in debt contains

Debt contracts particularly when long-term debt is involved, frequently restrict a firm’s ability to pay cash dividends such restrictions, which are designed to protect the designed to protect the position of lender, usually state that(1) future dividends can be paid only out of earnings generated after the signing of the loan agreement (that is, they cannot be paid out of past retained earnings ) and (2) that dividends cannot be paid when net workings capital (current assets minus current liabilities) is below a specified amount. Similarly, preferred stock agreements generally, state that no cash dividends can be paid on the common stock until all accrued preferred dividends have been paid.

d. Stability of earnings

A firm that has relatively stable earnings is often able to predict approximately when its future earnings will such a firm be therefore more likely to pay out a higher percentage of its earnings than is a firm fluctuating earnings. The unstable firm is not certain that subsequent years the hoped for earnings will be realized, so it is likely to retain a high proportion of current earnings. A lower dividend will be easier to maintain if earnings fall off in the future.

e. Profit rate

The expected rate of return on assets determines the relative attractiveness of paying out earnings in the form of dividends to stockholders (who will use then elsewhere) or using  them in the present enterprise.

f. Rate of asset expansion

The more rapidly a firm is growing, the greater its needs for financing asset expansion. The greater the future need for funds, the more likely the firm is to retain  earnings rather than pay then out. If a firm is to raise fund externally, natural sources or the present shareholders, who already know the company . But if earnings are paid as dividends and are subjected to high personal income tax rates, only a portion of them will be available for investment.

g. Access to the capital markets

A large, well established firm with a record of profitability and stability of earnings has access to capital markets and other forms of external financing. A small, new or venturesome firm, however, is riskier for potential investors. Its  ability to raise equity or debt funds  from capital markets is restricted, and it must return more earnings to finance its operations. A well-established firm is thus likely to have a higher dividend payout rate than is a new or small firm.

h. Control

Another important variable is the effect of alternative sources of financing on the control situation of the firm. As a matter of policy, corporations expand only to the extent of their internal earnings. This policy is defended on the ground that raising funds by selling additional common stock dicules the control of the dormant group in that company. At the same time, selling debt increases the risks of fluctuating earnings to the present owners of the company. Reliance on internal financing in order to maintain control reduces the dividend payout.