Dividend is the amount paid out to the shareholders out of the earnings for equity shareholders. That part of the total earnings, which is not paid out as dividend, is the retained earnings (RE), which is ploughed back or reinvested in the business. The higher the amount of dividend, the lower the retained earnings and vice versa. Retained profit increases the long-term capital base of the company and thus increases the potential of future earning capacity. On the other hand, the higher the dividend, the higher the earnings of the equity shareholders at present. The question is what is the trade-off between present earnings and higher future earnings; what is the optimum dividend policy. As in other matters, that dividend policy is optimum, which maximizes the net wealth of equity shareholders. The issue before dividend policy is to determine the best distribution of profit between dividend per share (DPS) and retained earnings per share (RES).
There are some aspects which may affect dividend policy of a firm. They are:
In addition to the percentage of dividend payout of a company over the long run, investors may value stable dividends over this period. Other things being equal, the market price of the shares of a company may be higher if it pays a stable dividend than if it pays a fixed percentage of its earnings, which may fluctuate. A stable policy implies not only maintaining a percentage of dividend payout in relation to earnings over the long run, but also the manner in which the actual dividend are paid. Rather than varying the dividends directly with changes in Earnings Per Share (EPS) every year, dividend can be maintained.
There are many reasons why an investor may pay higher price for the share of a company which follows a stable dividend policy. Dividend policy signals the financial health of a company and its future prospects (information content). Many investment institutions and individual investors prefer to include in their portfolio, shares of companies with a stable dividend policy in order to ensure their own steady cash flow. Although the investor can sell a portion of his stock for income when the dividend is not sufficient, such sales may have to be effected at a lower price, (consequent upon a lower dividend declaration).
A number of well-managed companies follow a policy or a target dividend payout ratio over the long run. Dividends are adjusted to changes in earnings, but only with a time lag. When earnings slowly increase year by year, dividends are increased only when the company is sure that the higher rate of dividend can be maintained.
The liquidity of a company is an important consideration in many dividend decisions. A company that is growing and profitable may not be liquid, because its funds may be locked up in fixed assets or permanent working capital. As the company may like to maintain some liquidity cushion to give it flexibility and protection against uncertainty, it may be reluctant to jeopardize this position in order to pay a large dividend. However, if a firm has the ability to borrow at short notice, it may be flexible in its dividend policy.
If a company pays substantial dividends, it may have to raise capital at a later time to finance; profitable investment opportunities. Such a course may sometimes lead to a dilution of management control, and for this reason, the present management may like to use retained earnings as the principal source of finance. However, this policy may act as a double-edged sword, and may actually harm the interest of the owner group. A low dividend payout may motivate the small individual shareholders to sell their shares to a take over tycoon, who may seize control by acquiring majority shares from the market.
4. Shareholding Pattern
In many of the closely held companies, the promoter group keeps a close watch on the pulse of the different shareholding groups and their preferences for dividends and/or capital gains. The dividend policy is formulated based on a consensus.
5. Timing of Investment Opportunities
A company may formulate long-term plans, and identify profitable investment opportunities. But if the proposed investment calls for funds after time lag of say, more than five years, it would be worthwhile to opt for a higher dividend payout immediately and go in for fresh equity or rights issue when the need for funds arises.
6. Legal Constraints
Sometimes term loan agreements – especially those under the soft loan scheme for modernization or as part of a package of revival of sick undertakings, stipulate that dividends should not be declared above a specified percentage for the stipulated period. Such a stipulation, in fact, helps the management in convincing shareholders about a lower payout ratio.