Question

Explain the factors affecting the dividend decision.

State any three factors affecting the dividend decision of a company.

State any four factors that affect the decision related to how much profit is to be distributed and how much profit is to be retained in the business. 

Explain the following factors affecting the dividend decision of the company:

1. Taxation Policy
2. Cash Flow Position

Explain any six factors affecting the decision that determines the amount of profit earned to be distributed and to be retained in the business.

Answer 1

The dividend decision of a company deals with what portion of the profits is to be distributed as dividends between the shareholders and what portion is to be kept as retained earnings. The following are the factors that affect the dividend decision.

1. Amount of Earning: A firm pays dividends from its current and past earnings. This implies that earnings play a key role in the dividend decision. A company with higher earnings will be in a position to pay a higher dividend to its shareholders. In contrast, a company with low or limited earnings would distribute low dividends.
2. Stable Earnings: When a company has stable and smooth earnings, they are in a position to distribute higher dividends compared to the companies with unstable earnings. In other words, a company with consistent and stable earnings can distribute higher dividends.
3. Stability of Dividends: This describes the regularity and predictability of dividend distributions throughout time. Companies promote steady dividend policies to show their financial stability and attract investors seeking regular income. Company dividend payout ratio is impacted by income stability, cash flow predictability, and future investment opportunities.
4. Growth Opportunities: Available growth opportunities affect a company's dividend decision. Management may choose to retain earnings rather than distribute them as dividends if the company has significant investment opportunities for profitable growth and expansion. By retaining earnings, companies can invest in new projects, research, acquisitions, and market expansion, resulting in stronger returns and increased shareholder value over time.
5. Cash Flow Position: Strong cash flow production and liquidity reserves can allow companies to pay dividends to shareholders without compromising operational and investment needs. Management considers the company's cash flow condition, future cash needs, and financial commitments when deciding dividend distributions to shareholders. 
6. Preference of the Shareholders: Shareholder preferences and expectations affect a company's dividend decision. Shareholders, including income-oriented investors and retirees, may value dividend income for passive income and capital preservation. Other owners, including growth-oriented or institutional investors, may prioritize capital appreciation and reinvestment to maximize long-term returns. Management examines shareholder preferences, communication channels, and feedback systems to balance dividend payouts and retained earnings with interests and expectations. 
7. Taxation Policy: Taxation policy plays an important role in deciding the dividends. The companies will likely distribute lower dividends if the taxation policy is such that a high tax rate is levied on dividend distribution. On the other hand, it might prefer to distribute higher dividends if the tax rate is low. When paying dividends, companies must consider the tax implications for both themselves and their shareholders. 
8. Stock Market Reactions: The amount of dividend that a company distributes affects its stock market prices. A company's dividend increase is viewed as a good sign by the investors, and the company's stock price goes up. On the other hand, a fall in dividends adversely affects stock prices. Thus, a company must consider the probable stock market reactions while taking a dividend decision.
9. Contractual Constraints: Sometimes, while giving out loans to a company, the lender may impose some restrictions as an agreement. These restrictions may be related to the dividend paid in the future. In such cases, the company has to keep such agreements in mind when distributing dividends.
10. Access to Capital Market: The availability and cost of external financing sources impact a company's dividend decision. Companies with greater access to the capital market tend to pay higher dividends. This is because they can rely less on retained earnings and more on other sources due to market access. The smaller companies with lower access to capital markets tend to pay lower dividends.
11. Legal Constraints: Legal constraints, such as corporate rules, regulations, and contractual commitments, might limit a company's capacity to pay dividends. Companies must follow regulatory requirements and constraints on dividend payments, such as solvency tests, capital conservation standards, and loan or bond covenants. Non-compliance with legal requirements can result in legal responsibilities, financial penalties, and reputational damage.