The announcement of dividends is one of the board of directors’ essential decisions to execute strategic and operational aspects of the Company. So, it’s important to manage the expectations of the shareholders and the Company’s needs for the financing. It’s not always the case that shareholders want higher dividends as their priority may be capital appreciation. So, the Company needs to understand the shareholders’ expectations, and there are several other important factors that affect the dividend policy. Let’s understand these factors and their impact on the process of decision-making related to dividend announcement.
These factors include but are not limited to financing needs of the Company, expectations of the shareholders, retained earnings, current year profitability, liquidity, dividend trend of the Company, borrowing ability of the Company, age of the Company, legal requirements, inflation, availability of investment opportunities, taxation policy, control objective, nature of the earnings and any debt priority, etc.
1) Financing Needs of the Company
The Company may have some strong investment opportunities available to them. However, to avail the opportunity, the Company needs certain funds that can be used from retained earnings. On the other hand, if the Company has paid dividends and is deprived of the retained earnings, it will have to opt for other sources of financing like debt and equity, which have a higher cost than retained earnings as per the pecking order theory.
However, if the Company does not have an investment opportunity and yet it holds the higher retained earnings and cash without paying a dividend, it may actually be a loss for the Company because holding excess cash has a massive cost.
2) Expectations of the Shareholders
The concept of the clientele effect is strongly applicable to the company’s dividend policy as some investors may belong to a clientele of the shareholders who want to get regular dividends as their day-to-day expenses depend on the stream of dividend income. On the other hand, some shareholders want a capital appreciation of the shares, which is possible when the Company does not pay a dividend and reinvest the same. So, the share price can increase.
Hence, if the Company believes its shareholders are small investors and depend on the dividend income, the Company needs to maintain stable dividend payments. On the other hand, if the Company believes its shareholders are large financial institutions, the Company may opt to limit payout and reinvest in the business for capital appreciation.
3) Retained earnings
If the Company has sufficient retained earnings, it can pay a higher dividend to the shareholders. Usually, companies are expected to pay a dividend with the retained earnings or the profit for the current year. If the Company has lower profitability in the current year, it can still afford to pay the dividend from retained earnings. However, if the Company does not have retained earnings and profit in the current year, it may opt for the debt to pay the dividend, which may not be a good signal for the company’s financial health.
4) Current year profitability
Current year profitability is considered one of the essential factors in deciding the amount for the dividend. It’s because dividend can be paid to the extent of current year earnings and the earnings of the previous years (retained earnings). Usually, companies with higher current-year earnings are expected to announce higher dividends and vice versa.
The Company may have massive profitability yet struggle to pay for the operating expenses on a timely basis. This may be due to inefficient management of the working capital. For instance, some big receivables of the Company may be stuck for a long time and creating problems in the availability of cash resources. So, the Company needs to have cash in hand/liquidity to make payment for the dividend. On the other hand, if there are liquidity problems, the Company may not make payment for the dividend despite being profitable.
6) Dividend trend
Some companies are well known for paying dividends regularly. These companies attract a specific clientele of shareholders that want a regular dividend. However, if they disturb the trend and lower the dividend payment, it might signal to the market that the Company is experiencing financial problems. So, the companies need to take care of their past trend in making decision about dividend.
7) Borrowing ability of the Company
Some companies have a strong asset base that can be used as a mortgage. So, these companies are said to have a strong borrowing capacity. On the other hand, if the company’s asset base is limited and it does not have an asset to mortgage, its borrowing ability is considered limited.
The companies with higher borrowing ability can adopt a stable dividend policy as they can use debt financing as a place of last resort in case of financing needs. While Companies with low borrowing ability should arrange some alternate financing when adopting a stable dividend policy. Although. Paying dividend with debt does not seem to be a good financial indicator.
8) Age of the Company
Suppose the company is mature and successfully executing its operations. In that case, it’s expected to have adequate capacity to generate a return and can afford to formulate a dividend policy with a stable dividend. On the other hand, if the Company is in a growing phase and does not have sufficient capacity to generate income, paying a stable dividend may not be a suitable policy.
9) Legal requirements
Although the Board of Directors has the discretion to set dividends per share, there are still certain legal repercussions that need to be considered before the dividend announcement. For instance, the dividend cannot be paid from the corporation’s capital but retained earnings. This law is known as capital maintenance law. This law protects the creditors of the Company as they stand first in case of the Company’s liquidation.
Further, several laws for dividend regulations include insolvency law, sector regulation, contract law, dividend legislation, and laws on Director’s duties, etc.
If the Company operates in an economy of higher inflation, it needs more financial resources to survive and execute its operations. For instance, with increasing inflation cost of working capital increases, and the Company needs to maintain the threshold of the reserves. So, it can’t afford a higher payout in inflationary environment and need to lower the dividend payout.
11) Investment opportunities
Sometimes, the Company has a pile-up of cash but no feasible investment opportunity. A feasible investment opportunity means an investment that is expected to generate a higher return than the cost of capital. So, if the Company opts for such investment that is not financially feasible, it will be a cause of loss for the shareholders. Hence, the Company may opt to pay for the dividend instead of accumulating free cash in such a case.
12) Taxation policy
There are two methods for the distribution of the return to the shareholders. These methods include paying a dividend and share price appreciation. Usually, dividend income is taxed at income tax rates, and share price appreciation is taxed as a capital gain.
In some jurisdictions, the capital gain tax might be exempt or have a lower rate of taxation than dividend income/income tax rate. So, in this case, capital appreciation may lead to the maximization of the return for shareholders. Hence, dividend policy may be framed in such a way that maximizes return for the shareholders by mitigation of the tax expenses.
Frequently asked questions
How is the control objective linked with the dividend policy?
If the Company maintains a stable dividend, it may have to face a scarcity of financial resources. Hence, the Company may have to obtain additional financing by issuing stock. On the other hand, it’s also a fact that issuing additional shares may dilute control of the existing shareholders. Hence, to avoid the situation, the companies may adopt a policy for being conservative for announcing higher dividends.
How nature of earnings affect the adoption of dividend policy?
If the Company has a stable business and its earning capacity is adequate, it can frame a stable dividend policy because earning predictions can be made with more confidence. It has also been observed that some sectors have stable earnings and some sectors have to face fluctuations in the earnings. For instance, companies operating in basic commodities are expected to have stable earnings. On the other hand, the companies operating in the luxury business are expected to face fluctuations in sales and earnings.
Hence, basic commodity sectors can frame a stable dividend policy. On the contrary, the stable dividend policy may not suit the companies dealing in luxury goods.