Six Factors Affecting Dividend Policy

Basically, when a corporation or company is in a profit position or has accumulated retained earnings or accumulated profit, such a corporation will consider distributing dividends. The dividend distribution typically depends on the dividend policy of each corporation. Thus, what are those factors affecting the dividend policy of a firm?

Before we jump to the 6 common factors affecting dividend policy, let’s understand some key points about dividend policy.

What is Dividend Policy?

Dividend policy is typically defined as the plan of action of a firm or corporation to follow whenever there is any dividend decision to be made.

Generally, each firm has its own dividend policy and this policy shall need to be developed consistently to align with the goal of a firm or corporation.

Six Factors Affecting Dividend Policy

As mentioned above, dividend distribution depends on the dividend policy of a firm. There are six main factors affecting the dividend policy of a firm. These are legal constraints, contractual constraints, internal constraints, growth prospects of a firm, owner considerations, and market considerations. In the later section below, we will discuss each of these 7 factors.

In some jurisdictions, there are legal constraints on the distribution of dividends.  A corporation is prohibited to distribute as cash dividends of a corporation’s legal capital. This legal capital is typically measured by the par value of the common stock of a firm. In some circumstances, the legal capital is also included paid-in capital in excess of par or share premium. The purpose of this legal capital is to provide a sufficient equity base in order to protect the claims from creditors of a firm or corporation.

2. Contractual Constraints

Typically, the contractual constraints come from the restriction in a loan agreement. When a corporation or firm enter into a loan arrangement and there are clauses prohibit the firm to distribute dividend if the retained profit of such firm is below the certain level or threshold as set out in the loan agreement. Thus, such a corporation cannot distribute the cash dividend; otherwise, the firm will break the loan covenants.

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Normally, the contractual constraints on dividends are inserted into the clause in the loan contract in order to help to protect the creditor against any possible insolvency position of a firm. This is because if there is no such clauses or threshold, the firm will try to distribute more dividend rather retained some portion of its profit for future uses or investment.

3. Internal Constraints

The internal constraints mainly associate with the available internal resources within the company. This includes the cash and other marketable security available which can be quickly converted into cash. The cash and other marketable security here are also called liquid assets.

This means that the firm has no enough liquid assets available; thus results in the limitation of the amount available for cash dividend distribution.

Typically, when a firm has a limited cash balance, such a firm can borrow funds to finance the dividend distribution. However, in practice, each firm or corporation does not want to borrow funds as financing sources for dividend distribution. Rather, they will distribute based on its available cash balance even though they have higher retained earnings available for distribution.

4. Growth Constraints

For a growing corporation, there is always a need for additional investments or assets. Thus, the level of the cash dividend will be limited as the firm needs cash for further investments to maintain growth.

Typically, the firms that grow rapidly; for instance, the high tech industry, will not be able to distribute a high cash dividend. This is because they cannot afford to lose the opportunity for further growth by injecting more investments. For this high growth industry, they are not interested in dividend but they are more interested in share price instead. The stockholders are normally influenced by the possibility of increasing high share price exceptionally and higher levels of dividends in the future.

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5. Owner Considerations

Basically, the dividend policy shall be established in a way that has a favorable effect on the majority of owners’ wealth. There is three main consideration in this case as follow:

Tax Status of Owners

In this consideration, if there are a majority of stock owners who are located in high tax jurisdictions or high tax brackets, they may not want a high dividend payout. This is because they will need to pay more taxes. Thus lowering down the dividend payout would allow them to delay the payment of taxes until they are able to sell out their stocks. Typically, when the owners sell the stock, it of course will subject to capital gain tax; however, this capital gain tax is more favorable than the taxes on the ordinary income as part of the dividend.

In contrast, the lower-income stockholders would need a higher dividend payout from their retained earnings. This is because they will be paying taxes based on the lower tax bracket and they might need such dividend income for further investment opportunities.

Owners’ Investment Opportunities

In this second consideration, a firm shall need to take into account the perspective of investment opportunities of shareholders. Basically, the firm should not retain funds in order to carry out investments or projects that provide lower returns. This is because if the firm distributes dividends, the shareholders are able to exploit the investment opportunity externally that can provide high returns. Thus, if the shareholders have the investment opportunities externally, the firm shall need to consider a high dividend payout so that to allow each shareholder to invest externally.

Potential Dilution of Ownership

When a firm has a high payout ratio, such a firm would have limited resources to cope with any investment opportunities. Thus, the firm might consider raising new equity capital through the common stock. When the firm raises new capital through common stock, it would result in a dilution of share or ownership of existing shareholders. In contrast, if the firm pays a low level of payout ratio, it could minimize the possibility of dilution of ownership.

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6. Market Considerations

The market consideration is further broken down into 3 consideration. These are fixed or increasing levels of dividend, continuous dividend payment, and informational content. In the first market consideration, stockholders are of opinion that the value of the fixed or increasing level of dividend is better than the fluctuation pattern of dividends particularly when the earnings are declining.

In the second market consideration, stockholders value the continuous dividend payment approach. This is because continuing to pay dividends, will result in an increase in the market value of the stock; thereby increase the shareholders’ wealth.

The last market consideration is information content. Typically, shareholders always view the dividend payment as a signal of a corporation’s future success. Thus, a stable and continuous dividend payment would result in a positive signal. In contrast, information regarding the loss or very low earnings would result in a negative signal. In addition, if the firm cannot make any payment of dividends would create the uncertainty of the firm’s future success; thereby lowering the stock value.

Conclusion

Every firm should have a proper dividend policy and such kind of policy should be in line with the goals, objectives as well as the firm’s strategies. The dividend policy should also take into account the 6 common factors as mentioned above that result in dividend policy consideration. 

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