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Determinants Of Dividend Policy

Determinants of Dividend Assignment / Homework Help

Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management.

Determinants of Dividend Policy

The main determinants of dividend policy of a firm can be classified into:
  • Dividend payout ratio
  • Stability of dividends
  • Legal, contractual and internal constraints and restrictions
  • Owner's considerations
  • Capital market considerations and
  • Inflation.

  • Dividend payout ratio

    Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm's shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives Ė maximizing the wealth of the firmís owners and providing sufficient funds to finance growth. These objectives are interrelated.
  • Stability of dividends

    Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:
    • constant dividend per share
    • constant dividend payout ratio or
    • constant dividend per share plus extra dividend
  • Legal, contractual and internal constraints and restrictions

    Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control.
  • Owner's considerations

    The dividend policy is also likely to be affected by the owner's considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership.
  • Capital market considerations

    The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
  • Inflation

    With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.

Bonus shares and stock splits

Bonus share is referred to as stock dividend. They involve payment to existing owners of dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus shares and stock splits. A stock split is a method commonly used to lower the market price of shares by increasing the number of shares belonging to each shareholder. Bonus shares may be issued to satisfy the existing shareholders in a situation where cash position has to be maintained.

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