Factors Affecting Dividend Policy
There is no definite answer to the question as to what should be the quantum of dividend every year. A number of factors affect it and the final figure of dividend is determined only after considering the following:
(1) Type of Business: The type of business carried on by the company influences the dividend policy. If the company is in a business which has a stable demand and stable earnings, it can follow a stable dividend policy. While a company which deals in luxury items has irregular flow of income and cannot adopt a steady dividend policy. Generally companies dealing in necessities of life, public utilities etc. have stable income.
(2) Current Year’s Earnings: A company has to determine the amount of dividend keeping in view the actual earnings of the current year only. Of course, the whole of earnings is not distributed by the company every year, but it is the base of dividend policy. Even the companies following stable dividend policy makes some changes within a certain limit on the basis of current year’s profit. There is no definite proportion between dividend and profit but dividend is raised, if the current year’s profit has increased considerably. As one author states, “The starting point of dividend policy is the earnings of the firm. The upper limit on dividends, practically speaking, is fixed by the earnings of the current period.”
(3) Past Dividends: To a lesser extent the dividends declared during previous years must also be considered. Shareholders do expect that the company would pay not less than dividend paid in the past. Of course, if circumstances change, departure has to be made from the past trend of dividends. But generally directors are reluctant to reduce the previous year’s rate of dividend and if need be, they would try to maintain the rate of dividend, withdrawing from the past accumulated profit.
(4) Estimate of Future Earnings: A company cannot adopt a stable dividend policy without taking into account the estimates of future earnings. The current year’s rate is rationally determined only when estimate of future earnings is considered. If the profit is likely to rise in future, then only the directors can think of raising current dividend. If the future is not so bright, the current dividend cannot be increased, as the rational dividend policy cannot ignore the fluctuations in earnings from year to year.
(5) Future Needs of Capital: The current profit is divided into retained earnings and dividend. When the company is in need of additional capital for future expansion of business, has to restrict its rate of dividend and keep a major part of its current earnings for meeting working capital needs and fixed capital requirements of expansion of business. Particularly small companies and newly established companies have no other source of raising finance and would therefore depend mainly on this source.
(6) Fluctuations in Business: The alternative waves of depression and boom in business has a considerable impact on dividend policy. A wise management would adjust itself to the changes in business from time to time. During boom period, a company should build up a good amount of reserves, so that it can withstand the period of depression and can maintain a stable dividend policy. If need be, the company can easily raise finance by maintaining high rate of dividend.
(7) Present Amount of Reserves: A company having sufficient amount of reserves would be able to face the times of low demand with confidence, the prudent management would therefore, try to build up, sufficient reserves during boom period by restricting the rate of dividend and thus try to strengthen its financial position. Of course, in India it has been made compulsory by Companies Act that companies are required to transfer not more than 10% of their net profits to Reserve if the rate of dividend exceeds 10% on graded rates. No company is allowed to transfer less than this to the reserves before declaring dividend.
(8) Distribution of Shareholdings: If the company is a closely-held, it is easy for the Board to postpone the dividend and transfer the entire profit to reserves. However, in case the shareholding is widely distributed, with a large number of shareholders, it would be difficult for the Board to take decision of reducing or suspending dividend. If shareholders are mostly from middle class group of society, they expect a higher and consistent rate of dividend and the directors cannot ignore the expectations of shareholders.
(9) Age of the Company: The dividend policy is affected by the fact whether a company is an old and established one or is a new one. A new company cannot afford to declare a high rate of dividend from the beginning, as it has to fall back on retained earnings for its requirements of funds for expansion. However, an established company would have built up enough reserves and can afford to be liberal in dividend distribution.
(10) Position of Liquidity: Dividend is payable in cash as per provisions of Companies Act. Hence, the directors are required to take into account the liquid position before declaring dividend. A company may have good deal of profit but may not have enough cash. In that case dividend has to be postponed or the lower rate of dividend should be declared. Even if the present liquid position may be satisfactory, the company may require cash to buy assets for expansion of business. In that case too, management should postpone payment of dividend. There is thus a direct link between liquid position and payment of dividend. A company which maintains a satisfactory level of liquidity at all times may be able to maintain stable dividend policy in the long run. In order to have a proper idea of cash flows which may help formulate dividend policy, it would be better to prepare a cash budget for say two to three years, which would give an idea to the management whether it would have enough cash to declare dividend.
(11) Government Policy: The changes in government fiscal policies, industrial and labour policies considerably affect the working of some or all of the business firms. Their profits are affected either favourably or adversely. Dividend policy has to be adjusted to such changes. In some cases, the government may restrict the rate of dividend in certain industries or impose tax if the rate of dividend exceeds a particular limit. Dividend policy is thus affected by changes in government policies.
(12) Taxation: Due to high rates of taxes, the company’s profits are reduced, leading to a lower rate of dividend. In case of closely-held companies the shareholders who are mostly in the highest tax brackets would like to receive less dividend and opt for capital gains. (It must be noted at this stage that dividends declared by Indian companies are completely tax-free in the hands of the shareholders and so this argument does not hold good). Many companies would like to issue bonus shares frequently instead of paying high rates of dividend.
(13) Legal Restrictions: The Companies Acts of various countries may put restrictions of payment of dividends. For example, according to Sec. 205 of Indian Companies Act, no dividend can be paid without providing depreciation on fixed assets, dividend has to be paid in cash, dividend warrants must be dispatched within 30 days of declaration of dividend etc. No dividend can be paid out of capital. It has to be paid out of earnings of the company. If the company declares a dividend in excess of 10%, it is required to transfer a particular percentage of profit on sliding scale to the reserve fund. It can make use of past accumulated profits for payment of dividend subject to certain rules issued by the Central Government. The objective of legal restrictions is to see that the paid up capital of the company is not reduced and the interest of creditors and shareholders is not adversely affected.
Sometimes even the suppliers of loans also stipulate certain restrictions on dividend in the agreements made with them.
(14) Attitude of Management: The attitude of management has considerable impact on dividend policy. The management with foresight and conservative attitude would declare lower dividend and major part of the profit would be kept in business to strengthen its financial position. The management with liberal attitude would be liberal in dividend policy. Prudent management would always adopt a bit conservative dividend policy.