The following practical problems have to be considered in making dividend decision:
(1) The Preference of shareholders – Dividend or Capital Gains.
(2) The Requirement of Company for Finance.
(3) Constraints on Paying Dividend.
(4) Stable or Irregular Dividend.
(5) Forms of Payment of Dividend.

(1) Preference of Shareholders: The shareholders are the real owners of the company and the management should give due consideration to the expectations of the shareholders. Most of the shareholders like to get maximum dividend in cash, while some shareholders like to get the benefit of capital gains in the form of appreciation in the value of shares. This is particularly the case of those investors who are in the maximum tax bracket, as they will have to pay less tax on capital gains.

In case of closely-held companies, the number of shareholders are few, and closely know one another or are from the same- group. The task of directors in determining dividend policy is not difficult in their case, as the directors have an idea of their expectations. Most of them are rich shareholders, who prefer capital gains to cash dividend and directors determine the dividend policy accordingly.

But in case of widely-held companies, the number of shareholders is very large. They have different requirements of dividends and capital gains. It is difficult in such case to determine a dividend policy which can satisfy all. The directors should find out the shareholders having substantial proportion of shares and try to satisfy their needs. A stable dividend policy must be established and continued for a long time, so that dominating proportion of shareholders would remain satisfied. The requirements of various types of shareholders may be as follows:

(a) Small shareholders buy a few shares of a few companies. They act on the advice of their brokers and friends. Even their purposes of investing in shares may be different. Some may be interested in regular dividends, while some like to have benefit of capital gains. Thus, they do not have a definite investment policy and they are not a dominating group among the shareholders.

(b) Wealthy investors are very much interested in dividend policy of the company. They prefer capital gains to regular dividend, as in that case they will have to pay less tax. They are generally in the high tax brackets and so they want that the company should retain most of its earnings with it and issue bonus shares. Some of them buy large block of shares and have a considerable influence on the dividend policy of the company.

(c) Retired and old persons are interested in regular dividend income. They invest their provident fund amount and savings with a view to getting regular income for consumption purposes. So they invest in shares of companies which pay regular and liberal dividends.

(d) Institutional investors like banks, insurance companies, Unit Trust etc. buy substantial shares of various companies and hold them for a very long time. They are interested in profitable investments and would prefer regular income.

Thus in widely-held companies, the interest of various groups of shareholders are in conflict and it is difficult to determine a definite dividend policy. In such a case, the policy should try to satisfy the dominating group of shareholders and follow such a policy for a long time. It should not be abruptly changed, as it would have created a clientele of investors who have been satisfied with the dividend policy.

(2) Requirement of Company for Finance: The directors should take into account the need of the company for funds required for growth and expansion. Of course, the shareholders would wish that they should get maximum dividend. But there are other parties linked with the company like employees, creditors, society, customers etc. and their interest demands that the company should retain some part of its earnings. The company should retain a major part of its earnings in the beginning to strengthen its financial position. A mature existing company can adopt a higher payout ratio. But even financially sound companies should also continue to retain some position of it earnings for diversification and to meet contingencies. The directors should neither adopt a policy of 100% pay out nor 100% retention. It is said that the company should retain its earnings when there exists profitable investment opportunities, that is when its rate of return is more than the its cost of capital or the rate which the shareholders expect. Conversely, when the company does not have more profitable investment avenues that is when its rate of return is less than its cost of capital, it should distribute most of its earnings to shareholders who can earn more by investing it in other companies.

Even here, it is the duty of directors to retain a part of earnings to strengthen the company’s financial position.

(3) Constraints on Paying Dividend: There are certain restrictions on payment of dividend, which the directors have to take into account.

(i) Legal Requirements: The dividend policy has to be determined in the legal framework. Government of every country puts certain restrictions on payment of dividend in public interest. For example, in India Sec. 205 of Indian Companies Act prescribes that the company can pay dividends only out of current profits after providing depreciation on its fixed assets or out of current profits after providing for depreciation on its fixed assets or out of past accumulated profits after providing for depreciation. This has to be complied with. Secondly, according to Companies Act dividend has to be paid in cash only. But the law has allowed companies to capitalize its reserves and issue fully paid bonus shares. Here again certain guidelines issued by SEBI have to be complied with. Thirdly, the company cannot pay dividend out of capital, as it would reduce the security available to creditors. Fourthly, a company is required to transfer a certain percentage of current profits to reserves before declaring dividend, if the rate of dividend exceeds 10% of its paid-up capital. The amount to be transferred is not more than 10% of its net profits. Thus the board has to restrict its dividend policy within the statutory requirements.

(ii) Restrictions by Loan Creditors: When a company obtains loan from external sources, the creditors may put certain restrictions to protect their interest. The restrictions may be that the company cannot pay dividend until it reaches a certain level of earnings or it may be a limit on the percentage of dividend. If may also be in the form of a certain percentage of net earnings as retention ratio. If such stipulations are not observed, there may be a penalty in the form of the whole amount of principal and interest becoming payable immediately.
(iii) Liquidity: The liquidity of funds is a very important consideration with regard to dividend policy. If the company has enough liquid resources, it can easily pay dividend. However, certain companies may have earned handsome profits, but may not have enough cash to pay dividend. Particularly in case of companies which are newly established, or which are likely to embark upon an expansion plan or which has to redeem its debentures very shortly may be in such a position. They have to keep their pay out ratio lower. But mature companies, would have enough liquid assets and they have few profitable investment opportunities and so they are able to pay liberal dividend. Liquidity is thus a very important constrain of dividend policy.

(iv) Financial Position: The dividend policy is also constrained by the financial condition of the company. If the firm is a mature firm, it will have’ enough retained earnings and also it has an easy access to external sources of funds. It can therefore afford to adopt a liberal dividend policy. It is not so with the growth firm, as it will not have sufficient reserves and may not have easy access to external funds. The second point is that the company which has high debt-equity ratio will have heavy burden of interest charges and so is quite valuable to changes in earnings. Such firms have to retain a large part of its earnings to strengthen its equity base.

(v) Maintaining Control: The desire of management or a group of shareholders to maintain control over the company has a strong influence on dividend policy. If a company pays high dividends, its liquid position will be adversely affected and it will have to issue new shares to raise additional funds to invest in new profitable opportunities. In such a situation, the management group, which is not able to buy the additional shares may loss control, as another group may buy a large chunk of the new issue. The management which wants to retain control, in such a case, would retain major part of earnings and resort to low pay-out ratio.

(vi) Stability of Earnings: A firm having a stable income over a long period of time will be more liberal in its dividend policy. Of course, the level of earnings is also a factor to be considered. But, it is doubtless that stability of earnings has a significant impact on formation of dividend policy. In case of public utilities and firms dealing in necessities of life, there would be relatively stable earnings and they can afford to be liberal in payout ratio. A firm having fluctuating earnings would have to be very careful in determining its dividend policy, as it would not be able to adopt a stable dividend policy.

(vii) Opportunities for Growth: When a firm has more profitable opportunities available for investment, it will follow a policy of high retention and low pay out ratio. Particularly, the growth firms, which wants to grow and develop will be following a policy of high retention, as it will have difficult access to external sources of finance. However, one thing must be remembered that this policy of low dividends should be followed only when profitable investment opportunities are available. Otherwise, the earnings retained cannot be profitably employed and the return from such investment may be lower than the expectations of investors, resulting in lowering of owners’ wealth. In such a situation, it would be better to pay high dividends, so that shareholders can invest it at a higher rate of return. If such firms need funds for expansion, it can raise funds externally.

(viii) Access to Capital Markets: The fact whether a firm has easy access to capital market or limited access has an important bearing on determination of dividend policy. If a firm has an access to capital market, it can afford to adopt liberal dividend policy. Only financially strong or large-sized firms have such an advantage. If the firm does not have easy access to capital market, it cannot raise funds externally easily and so it will have to depend more on retained earnings for funds required for its expansion programmes. Secondly, in order to be eligible to get finance from financial institutions, the firms are required to declare a minimum dividend for at least some years. This consideration also affects the dividend policy. As these financial institutions are big buyers of corporate securities, it adds prestige to the security of the firm.

(ix) Inflation: Inflation or continuously rising prices have an impact on dividend policy. When prices are rising, the assets become costlier while depreciation is charged only on old historical values, as replacement value depreciation is not allowed by income-tax authorities. Hence, when assets are to be replaced, the amount of depreciation accumulated is not enough to buy new assets. The firms have therefore to rely on retained earnings for this purpose and have to retain greater part of earnings for replacement.