Dividend Policy Theory
Dividend decision by any company is an important issue to be determined by the financial management. The important point is to determine how much earnings are to be distributed to shareholders and how much amount is to be retained in the firm, what is the dividend pay out ratio and what should be the retention ratio. Dividend pay out ratio is the percentage of earnings paid by way of dividend, while retention ratio is the percentage of earnings retained by the firm, not distributed as dividend.
Dividend policy decision has a significant effect on the credit standing of the firm, its share prices and its future growth. If the firm follows a liberal dividend policy, it will not be able to build sufficient internal resources and its future growth may be hampered leading to fall in the value of the firm. Another consequence of the liberal dividend policy is that the shareholders will receive higher dividends and would be satisfied as most of the investors have preference for current income. But that would also reduce their chances of capital gains. Of course, in respect of preference dividend, the management has little freedom, as its rate of dividend is fixed and it has to be paid in priority to dividend paid to equity shareholders. Similarly, there are certain restrictions on the payment of dividend placed by the government and they have to be abided by. The management has no freedom in that respect.
The dividends and retained earnings are the two alternative aspects of financial decision. If it is decided to pay a particular amount as dividend, the remaining earnings become the retained earnings.
Conversely, if it is decided to retain a particular amount of earnings as retained earnings, the balance of earnings automatically becomes dividend amount. Thus both decisions are complementary to each other. No decision can be taken independent of the other.
Another important aspect of dividend policy is whether the dividend decision is taken first or whether the retention decision should be made first. There is no rule and it all depends upon the circumstances available in the firm. If the firm has on hand some investment programme of growth, expansion or replacement, which requires a particular amount to be invested, then the retention decision is first taken. However, it is generally the dividend decision which is made first.