Top 10 Factors for Consideration of Dividend Policy

This article throws light upon the top ten factors for consideration of dividend policy. The factors are: 1. General State of Economy 2. Capital Market Considerations 3. Legal, Contractual Constraints and Restrictions 4. Tax Policy/Tax Consideration 5. Inflation 6. Stability of Dividends 7. Dividend Pay-Out (D/P) Ratio 8. Owner’s Considerations 9. Nature of Earnings 10. Liquidity Position.

Factor # 1. General State of Economy:

As a whole, it affects the decision of the management to a great extent whether the dividend should be retained or the same should be distributed amongst the shareholders.

In the following cases, the business may prefer to retain the whole or part of the earnings in order to build up reserves:

(i) Where there are uncertain economic and business conditions;

(ii) If there is a period of depression (management may withhold the payment of dividends for maintaining the liquidity position of the firm);

(iii) If there is a period of prosperity (since there is large profitable investment opportunities); and

(iv) Where there is a period of inflation.

Factor # 2. Capital Market Considerations:

This also affects the dividend policy to the extent to which the firm has access to the capital market In other words, if easy access to the capital market is possible whether due to financially strong or, big in size, the firm in that case, may adopt a liberal dividend policy.

In the opposite case, i.e., if easy access to capital market is not possible, it must have to adopt a low dividend pay-out ratio, i.e., they have to follow a conservative dividend policy. As such, they must have to rely more on their own funds, viz retained earnings.

Factor # 3. Legal, Contractual Constraints and Restrictions:

This is one of the most significant factors which are to be taken into account while considering dividend policy of a firm since it has to be evolved within the legal framework and restrictions. It is not legally binding on the part of the directors to declare dividends.

Dividend shall be declared or paid only out of current profit or past profits after charging depreciation although the Central Government has empowered to allow any company for paying dividends out of current profits for any financial year before charging depreciation.

The dividend must be paid in cash although a company can capitalize its profits/reserves for the purpose of issuing fully paid bonus shares or making partly paid shares into fully paid. Capital profits cannot be distributed by way of dividend.

Sometimes a company may declare dividend out of past accumulated profits if the Central Government so permits Moreover, the Indian Income-tax Act also prescribes certain restrictions about the payment of dividend. From the above, it becomes clear that the directors while declaring dividends, should consider all the relevant legal formalities prescribed by the Companies Act, Income-tax Act etc.

Contractual restrictions, on the other hand, which are imposed by certain lenders of the firm also affect the dividend policy of a firm. Because, they impose certain conditions about the payment of dividend particularly, during the period when the firm is experiencing liquidity or profitability crisis.

For instance, there may be an agreement between the firm and the lenders that the former shall not pay dividend to its shareholder more than 10% until the loan is repaid or dividend shall not be declared if the liquidity ratio is found to be less than 1:1.

Factor # 4. Tax Policy/Tax Consideration:

The tax policy which is followed be a Government also affects the dividend policy of a firm. Whether it is better to declare and pay dividend in cash or by the issue of bonus shares, depends to some extent on the tax policy. Because, cash dividends are not even so attractive to the investors who are in higher tax brackets.

For this purpose, a firm should follow a tax-oriented dividend policy by:

(i) Not declaring dividends and assisting the shareholders to secure their returns by the sale of appropriated shares,

(ii) Following a policy of regular share dividend in lieu of cash dividend,

(iii) Using classified equity share dividend.

Factor # 5. Inflation:

Inflation may also affect the dividend policy of a firm. With rising prices, funds which are generated by way of depreciation may fall short in order to replace obsolete equipment. The shortfall may be made from retained earnings (as a source of funds). This is very significant when the assets are to be replaced in the near future. As such, the dividend pay-out ratio tends to be low during the periods of inflation.

Factor # 6. Stability of Dividends:

It should be given due weight-age for this purpose although the same may differ from one firm to another. The dividend policy, of course, should have a degree of stability, i.e., earnings/profits may fluctuate from year to year but not the dividend since the equity shareholders prefer to value stable dividends than the fluctuating ones.

In other words, the investors favour a stable dividend in as much as they do the payment of dividend. Stable dividends refer to the consistency or lack of vari­ability in the stream of dividends, payments, i.e., a certain minimum amount of dividend should be paid regularly.

The stability of dividends can be in any of the following three forms:

(a) Constant Dividend Per Share;

(b) Constant Percentage of Net Earnings (Constant D/P ratio); and

(c) Constant Dividend Per Share plus Extra Dividend.

(a) Constant Dividend Per Share:

Under this form, a firm pays a certain fixed amount per share by way of dividend. For example, a firm may pay a fixed amount of, say, Rs. 5 as dividend per share having a face value of Rs. 50, The Fixed amount would be paid regularly year after year irrespective of the actual earnings, i.e., the firm will pay dividend even if there is a loss.

In short, fluctuation in earnings will not affect the payment of dividend. Of course, it does not necessarily mean that the amount of dividend will remain fixed for all times in future.

When the earnings of the company will increase the rate of dividend also will increase provided the new level can be maintained in future. If there is a temporary increase in earnings, there will not be any change in the payment of dividends.

The relationship between the EPS (Earning per share) and DPS (Div­idend per share) can better be represented with the help of the following diagram:

From the above, it becomes clear that earnings (EPS) may fluctuate from year to year but the DPS is constant. In order to formulate this policy, a firm whose earnings are not stable may have to make provisions to those years when there is higher earnings, i.e., a Dividend Equalization Reserve’ fund may be created for the purpose.

(b) Constant Percentage of Net Earnings:

According to this policy, a certain percentage of the net earnings/profits is paid by way of dividend to the shareholders year after year, i.e., when a constant pay-out ratio is followed by a firm. In other words, it implies that the percentage of earnings paid out each year is fixed and as such, dividends would fluctuate proportionately with earnings.

This is particularly very useful in cases where there are wide fluctuations in the earnings of a firm. This policy suggests that when the earnings of a firm decline the dividend would naturally be low.

For instance, if a firm adopts a 40% dividend pay-out ratio (it indicates that for one rupee earned, it will pay 40 paisa to the shareholders), i.e., if a firm earns Rs. 5 per share then it will pay Rs. 2 to the shareholders by way of dividend. The relationship under this policy between the EPS and DPS is presented below with the help of a diagram that shows.

(c) Constant Dividend Per Share Plus Extra Dividend:

Under this policy, firm usually pays a fixed dividend per share to the shareholders. At the time of market prosperity, additional or extra dividend is paid over and above the regular dividend. This extra dividend is waived as soon as the normal conditions return.

Now, the questions that arise before us are which one is the most appropriate one and what is their relative suitability or which one is most favourable to the investors or what are the implications to the shareholders.

The most appropriate policy may be considered as the first one, viz.. Constant Dividend Per Share. Because, most of the investors desire a fixed rate of return from their investment which will gradually increase over a period of time.

This is satisfied by the said policy. But in case of Constant percentage (of net earnings) the return actually fluctuates with the amount of earnings and it also involves uncertainties and that is why it is not preferred by the shareholders although the same is favoured by the management since it correlates the amount of dividends to the ability of the company to pay its dividend.

At the same time, in case of Constant Dividend per Share plus Extra Dividend, there is always an uncertainty about the extra dividend and as a result it is not generally preferred by the shareholders.

A stable dividend policy is advantageous due to the following:

(i) Desire for Current Income:

There are investors, like, old and retired persons, widows etc., who desire to have a stable income in order to meet their current living expenses since such expenses are almost fixed in nature. Such a stable dividend policy will help them.

(ii) Resolution of Investors’ Uncertainly:

If a firm adopts a stable dividend policy, it must have to declare and pay dividend even if the earnings are temporarily reduced. It actually conveys to the investors that the future is bright.

On the contrary, if it follows a policy of changing dividend with cyclical changes in the rate of earnings, the investors will not be confined about their return which may induce them to require a higher discount factor. The same is not desired in case of a stable dividend policy.

(iii) Raising Additional Finance:

If stable dividend policy is adopted by a firm, raising additional funds from external sources become advantageous on the part of the company since it will make the shares of a firm an investment. The shareholders/investors will hold the shares for a long time as it will create some confidence in the company and as such, for further issue of shares, they would be more receptive to the offer by the company.

This dividend policy also helps the company to sale preference shares and debentures. Because, past trend regarding the payment of dividend informs them that the company has been regularly paying the dividends and their interest/dividend naturally will be paid by the company when it will mature for repayment together with the principal.

(iv) Requirements of Institutional Investors:

Sometimes the shares of a company are purchased by financial institutions, like, IFC, IDB, LIC, UTI etc., educational and social institutions in addition to the individuals.

These financial institutions are the largest purchasers of shares in corporate securities in our country and every firm is intended to sell their shares to these institutions. These financial institutions are interested to buy the shares of those companies who have a stable dividend policy.

Danger of Stability of Dividends:

Once this policy is being adopted by a firm it cannot be changed with an immediate effect which will adversely affect the investors’ attitude towards the financial stability of the company. Because, if a company, with stable dividend policy, fails to pay the dividend in any year, there will be a severe effect on the investors than the failure to pay dividend under unstable dividend policy.

That is why, in order to maintain that rate, sometimes the directors pay dividend, even if there is insufficient earning, i.e., declaring dividend out of capital which ultimately invites the liquidation of a firm.

The rate of dividend should be fixed at a conservative figure which is possible to pay even in a lean period for several years. Extra dividend can be declared out of extra earnings which, in other words, will not create any adverse effect in future.

Factor # 7. Dividend Pay-Out (D/P) Ratio:

Dividend Pay-out (D/P) ratio (i.e., percentage share of the net earnings/profits distributed to the shareholders by way of dividends) also affects the dividend policy of a firm. It involves the decisions either to pay out the earnings or to retain the same for re-investment within the firm. Needless to mention that retained earnings also constitute a reliable source of funds.

Therefore, if dividend is paid, cash will be reduced to that extent. For maintaining assets level and financing investment oppor­tunities, a firm should obtain necessary funds either from the issue of additional equity shares or from debt and consequently if the firm fails to raise funds from outside, its growth will be adversely affected.

So, payment of dividends imply outflow of cash which adversely affect the future growth of the firm. In short, it affects both the owner’s wealth as well as the long-term growth of a firm. Thus, the optimum dividend policy should strike that balance between current dividends and future growth which maximise the price of the firm’s share.

Therefore, this ratio will have to be determined in such a manner so that it will maximise the firm’s wealth and at the same time, will provide sufficient funds for the growth in future.

Factor # 8. Owner’s Considerations:

The dividend policy is also to be affected by the owner’s consideration of:

(a) Their opportunities of investment; and

(b) The dilution of ownership.

(a) Owner’s opportunities of Investment:

If the rate of return which is earned by a firm is less than the return which have been earned by the investors from outside investment, a firm should not retain such funds, which in other words, will be detrimental to the interest of the members although it is difficult to ascertain the rate of alternative investment as well as alternative investment opportunities of its shareholders.

Of course, the firm may evaluate such external rate from the firms belonging to the same risk class.

And if is found that the said rate is comparatively high, it should opt for a high (D/P) ratio or vice-versa. Thus, while deciding dividend policy of a firm, external investment opportunities should also be carefully considered.

(b) Dilution of Ownership:

A high (D/P) Ratio recognises the dilution of ownership both from the standpoint of control as well as from the view point of earnings of the existing shareholders. These two aspects adversely affect the existing shareholders right.

Because, in the latter case, (dilution of earnings) low retentions may compel the firm to issue first equity shares which will increase the total number of equity shares and as such, the same will lower the earning per share (EPS) and market price will go down conse­quently. On the contrary, if percentage of retained earnings becomes high, dilution of earnings will be minimised.

Factor # 9. Nature of Earnings:

If the income of a firm is stable, it can afford, a higher dividend pay-out ratio in comparison with a firm which has not such stability in its income. For instance, public utility consensus can have a higher dividend pay-out ratio since they have some monopoly rights which are not enjoyed by other companies who operate in a highly competitive market.

Factor # 10. Liquidity Position:

While deciding the dividend policy, the liquidity aspect should also be considered. Because, if dividend is paid in cash, there is an outflow of cash. It is interesting to note in this regard that a firm may have an adequate income/profit but it may not have sufficient cash to pay dividend.

Thus, it is the duty of the management to see the cash position i.e., liquidity aspect, before and after the payment of dividends at the time of taking decision about the dividend policy of a firm. If there is a shortage of cash, question of payment of dividends does not arise, even if the company makes a sufficient profit.

This problem is, particularly, to be faced by new firms who are still in the process of extension and development. One particular point is to be noted by the management, i.e, to see that the liquid ratio must not be less than 1: 1 after the payment of dividends.