Question

Ananta Ltd. is a company dealing in ready-made garments for the last many years. Recently the profit of the company has started increasing. The finance manager decided to retain the profit instead of distributing it among shareholders.

1. Identify and state the financial decision taken by the finance manager in the above case.
2. State any three factors affecting the decision identified in (i) above.

Answer 1

1. Dividend Decision: A dividend is a portion of the profit that is distributed to shareholders. The decision involved here 1s how much of the profit earned by the company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business. While the dividend constitutes the current income reinvestment as retained earnings increase the firm's future earning capacity. The extent of retained earnings also influences the financing decision of the firm. Since the firm does not require funds to the extent of re-invested retained earnings, the decision regarding dividends should be taken keeping in view the overall objective of maximizing shareholder's wealth.
2. Factors affecting dividend decisions are as follows:
   (a) Amount of Earnings: Dividends are paid out of the current and past earnings. Therefore, earnings are a major determinant of the decision about dividends.
   (b) Stability Earnings: Other things remain the same, a company having stable earnings is in a better position to declare higher dividends. As against this, a company having unstable earnings is likely to pay a smaller dividend.
   (c) Stability of Dividends: Companies generally follow a policy of stabilising dividends per share. The increase in dividends is generally made when there is the confidence that their earning potential has gone up and not just the earnings of the current year. In other words, the dividend per share is not altered if the change in earnings is small or seen to be temporary in nature.
   (d) Growth Opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies is, therefore, smaller than that in the non-growth companies.
   (e) Cash Flow Position: The payment of dividends involves an outflow of cash. A company may be earning profit but may be short on cash. The availability of enough cash in the company is necessary for the declaration of dividends.
   (f) Shareholders' Preference: While declaring dividends, management must keep in mind the preferences of the shareholders in this regard. If the shareholders in general desire that at least a certain amount is paid as dividends, the companies are likely to declare the same. There are always some shareholders who depend upon a regular income on their investments.
   (g) Taxation Policy: The choice between the payment of dividends and retaining earnings is, to some extent, affected by the difference in the tax treatment of dividends and capital gains. If the tax on dividends is higher, it is better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower. Though the dividends are free of tax in the hands of shareholders, a dividend distribution tax is levied on companies. Thus, under the present tax policy, shareholders are likely to prefer higher dividends.
   (h) Stock Market Reaction: Investors, in general, view an increase in dividends as good news and stock prices react positively to it. Similarly, a decrease in dividends may have a negative impact on the share prices in the stock market. Thus, the possible impact of dividend policy on the equity share price is one of the important factors considered by the management while taking a decision about it.
   (i) Access to Capital Market: Large and reputed companies generally have easy access to the capital market and, therefore, may depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market.
   (j) Legal Constraints: Certain provisions of the Companies Act place restrictions on payouts as dividends. Such provisions must be adhered to while declaring the dividend.
   (k) Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in the future. The companies are required to ensure that the dividend does not violate the terms of the loan agreement in this regard.