10 Most Important Determinants of Dividend Policy | Financial Management

Some of the most important determinants of dividend policy are: (i) Type of Industry (ii) Age of Corporation (iii) Extent of share distribution (iv) Need for additional Capital (v) Business Cycles (vi) Changes in Government Policies (vii) Trends of profits (vii) Trends of profits (viii) Taxation policy (ix) Future Requirements and (x) Cash Balance.

The declaration of dividends involves some legal as well as financial considerations. From the point of legal considerations, the basic rule is that dividend can only be paid out profits without the impairment of capital in any way. But the various financial considerations present a difficult situation to the management for coming to a decision regarding dividend distribution.

These considerations are discussed below:

(i) Type of Industry:

Industries that are characterised by stability of earnings may formulate a more consistent policy as to dividends than those having an uneven flow of income. For example, public utilities concerns are in a much better position to adopt a relatively fixed dividend rate than the industrial concerns.

(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant improvement and expansion, while old companies which have attained a longer earning experience, can formulate clear cut dividend policies and may even be liberal in the distribution of dividends.

(iii) Extent of share distribution:

A closely held company is likely to get consent of the shareholders for the suspension of dividends or for following a conservative dividend policy. But a company with a large number of shareholders widely scattered would face a great difficulty in securing such assent. Reduction in dividends can be affected but not without the co-operation of shareholders.

(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has got a considerable influence on the dividend policy. The income may be conserved for meeting the increased requirements of working capital or future expansion.

(v) Business Cycles:

During the boom, prudent corporate management creates good reserves for facing the crisis which follows the inflationary period. Higher rates of dividend are used as a tool for marketing the securities in an otherwise depressed market.

(vi) Changes in Government Policies:

Sometimes government limits the rate of dividend declared by companies in a particular industry or in all spheres of business activity. The Government put temporary restrictions on payment of dividends by companies in July 1974 by making amendment in the Indian Companies Act, 1956. The restrictions were removed in 1975.

(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to find out the average earning position of the company. The average earnings should be subjected to the trends of general economic conditions. If depression is approaching, only a conservative dividend policy can be regarded as prudent.

(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the residual profits after tax available for shareholders and indirectly, as the distribution of dividends beyond a certain limit is itself subject to tax. At present, the amount of dividend declared is tax free in the hands of shareholders.

(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the business, to finance future- expansion of the business and to modernise or replace equipments of the enterprise. The conflicting claims of dividends and accumulations should be equitably settled by the management.

(x) Cash Balance:

If the working capital of the company is small liberal policy of cash dividend cannot be adopted. Dividend has to take the form of bonus shares issued to the members in lieu of cash payment.

The regularity of dividend payment and the stability of its rate are the two main objectives aimed at by the corporate management. They are accepted as desirable for the corporation’s credit standing and for the welfare of shareholders.

High earnings may be used to pay extra dividends but such dividend distributions should be designed as “Extra” and care should be taken to avoid the impression that the regular dividend is being increased.

A stable dividend policy should not be taken to mean an inflexible or rigid policy. On the other hand, it entails the payment of a fair rate of return, taking into account the normal growth of business and the gradual impact of external events.

A stable dividend record makes future financing easier. It not only enhances the credit- standing of the company but also stabilises market values of the securities outstanding. The confidence of shareholders in the corporate management is also strengthened.

Legal rules governing payment of dividends:

It is illegal to pay a dividend, if after its payment; the capital would be impaired (reduced). This requirement might be met if only capital surplus existed. An upward revaluation of assets, however, would create a capital surplus, but at the same time might operate as a fraud on creditors and for that reason is illegal.

Basically the dividend laws were intended to protect creditors and therefore prohibit payment of a dividend if a corporation is insolvent or if the dividend payment will cause insolvency.

The corporate laws must be taken into consideration by the directors before they declare a dividend. The company can postpone the distribution of dividend in cash, which may be conserved for strengthening the financial condition of the company by declaring stock dividend or bonus shares.

To sum up, the decision with regard to dividend policy rests on the judgement of the management, since it is not a contractual obligation like interest. The formulation of dividend policy requires a balanced financial judgement by judiciously weighting the different factors affecting the policy.

Stock dividend or bonus shares:

A stock dividend is a distribution of additional shares of stock to existing shareholders on a pro-rata basis i.e. so much stock for each share of stock held. Thus, a 10% stock dividend would give a holder of ICQ shares, as additional 10 shares, whereas a 250% stock dividend would give him 250 additional shares. A stock dividend has no immediate effect upon assets.

It results in a transfer of an amount from the accumulated earnings or surplus account to the share capital account. In other words, the reserves are capitalised and their ownership is formally transferred to the shareholders.

The equity of the shareholders in the corporation increases. Stock dividends do not alter the cash position of the company. They serve to commit the retained earnings to the business as a part of its fixed capitalisation.

Reasons for declaring a stock dividend:

Two principal reasons which usually actuate the directors to declare a stock dividend are:

(1) They consider it advisable to reduce the market value of the stock and thereby facilitate a broader distribution of ownership.

(2) The corporation may have earnings but may find it inadvisable to pay cash dividends. The declaration of a stock dividend will give the stock holders evidence of the increase in their investment without interfering with the company’s cash position. If the stock holders prefer cash to additional stock in the company, they can sell the stock received as dividend.

Sometimes, a stock dividend is declared to protect the interests of old stock holders when a company is about to sell a new issue of stock (so that new shareholders should not share the accumulated surplus).

Limitations of stock dividends:

The bonus shares entail an increase in the capitalisation of the corporation and this can only be justified by a proportionate increase in the earning capacity of the corporation. Young companies with uncertain earnings or companies with fluctuating income are likely to take great risk by distribution stock dividends.

Every stock dividend carries an implied promise that future cash dividends will be maintained at a steady level because of the permanent capitalisation of reserves. Unless the corporate management has reasonable grounds of entertaining this hope, the wisdom of large stock dividend is always subject to grave suspicion.

The existence of legal sanction for distributing the accumulated earnings or reserves does not warrant the issue of stock dividends from the point of view of sound financial practice. There should be other conditioning factors also for the issue of stock dividend.

(a) Bonus shares bring about a capitalisation of undistributed profits in the companies where the profits originate and this lead to a linear development of corporate enterprise and greater concentration of economic power.

(b) By issuing stock dividends-the corporations deprive the capital market of ‘secondary’ funds which would otherwise have flowed into more widely dispersed investments.

(c) Bonus shares enable companies to appropriate to their own use undistributed profits which, otherwise, would have led either to an increase in the share of labour or a reduction in prices for the consumer.

Submitted by : Dr. Camila, Category : Financial Management, Tag : Policies