Updated July 19, 2023
Introduction to Dividend Policy
When the company makes a profit, it can do two things with that profit i.e. either the company can retain that profit with it for some future purpose or it can distribute that profit to the shareholders and the process of distribution of profits to the shareholders is called the dividend payout and the policy under which the company distributes the dividend to its shareholders is called the dividend policy.
It is made by the board of directors of the company. As the decision of distribution of profits in the form of dividends is undertaken by the board, it is the board of directors of the company who decides the content of the dividend policy considering different factors like growth and future assignments and projects. It contains information on the number of dividends to be distributed along with the frequency of distribution of dividends. The value of the enterprise is affected by the dividend policy.
Objectives of Dividend Policy
- The most important objective is the improvement of the financial health of the company. This objective also takes into consideration shareholder’s wealth as the shareholder of the company plays a very important role in the company’s growth.
- The distribution of dividends increases the cash outflow of the company and hence less cash is available to the company after the distribution of dividends. If in the future, the company wants to acquire any new project or if it wants to expand its business, with the available little cash, it cannot go for a new acquisition or expansion. In this case, it has to take the help of external financing which will result in the extra cost of interest to the company. Hence, consideration of future projects is also one of the important objectives of dividend policy.
- The rate of dividend distribution should be consistent over the years because large fluctuations in the rate affect the market price of the share. Hence the consistency in the rate of distribution of dividends is also one of the objectives of dividend policy.
- If the company takes the help of external finances, it puts doubts on the financial position of the company in the eyes of shareholders. Hence, shareholders can move from the company and it can result in the dilution of existing shareholders of the company. Hence, the dividend policy should be conservative so that the existing shareholders do not get hampered due to the policy.
How Does It Work?
It provides the shareholders with the idea of dividend they will receive in the future. Hence the company gains the confidence of the shareholders and the investment ratio gets increased which improves the market value of the shares of the company.
Example
For example, there is a company XYZ ltd. which has the policy to distribute 10% of its earnings as the dividend to its shareholders. So the company is following the stable dividend policy. In this case, the amount of dividends will fluctuate on the basis of fluctuations in the earnings of the company.
Types of Dividend Policy
The following are the types are:
- Fixed/regular Dividend Policy: In fixed or regular dividend policy, the dividend is paid by the company every year irrespective of the making of profits or losses. Shareholders gets the fixed amount of dividend every year whether the company making profit or loss. If the company earns more profits than normal, it can transfer the amount left out after the distribution of dividends to the shareholders in the retained earnings account. And if the company makes losses, in that case also it has to distribute the fixed amount of dividend to the shareholders.
- Stable Dividend Policy: In stable dividend policy, the percentage of dividend of profits to be paid to shareholders is fixed instead of the amount of dividends.
For example: The company sets out that it will pay 5% of profits as the dividend payout to the shareholders irrespective of the amount of profits it has earned. In this type, shareholders face the lot of uncertainty as they don’t have any idea of how much amount of dividends they are going to receive for the year. - Irregular Dividend Policy: In this type there is no such certainty of receipt of dividend to the shareholders of the company. The company is under no obligation to share the amount or share of profits to the shareholders. If it has earned a large amount of profit in any particular year, it can distribute any amount of profits as a dividend. In this case, the distribution of dividend solely depends on the discretion of the company. for the shareholders, it can be highly risky to invest in a company as there is risk of not receiving any dividend in any year.
- No Dividend Policy: Some of the companies do not at all distribute any amount of its profit as the dividend. this is because, whatever the profits it has earned, its transfers that amount in retained earnings account to be used for expansion or acquisition of future projects. This makes the company grow fast and also the value of its shares get increases.
Factors Affecting their Dividend Policy
The following are the factors:
- It gets affected by the type of industry to which it belongs.
- In the industries where the earnings are stable, consistent dividend policy can be applied and the industries in which earnings are not stable, consistent dividend policy cannot be applied. hence the structure of the industrial earnings is very important factor to decide the pattern of dividend policy.
- The ownership structure of the company is also important to factor of dividend policy.
- Where there is higher share of promoters holding in the company there is always the low dividend payout is found. because the higher payout of dividends may cause a decline in the value of the stock of the company.
- The age of the company is also one of the crucial factors that affect the dividend policy of the company. newly formed companies basically do not have high dividend payout ratio in the beginning of formation because they retained their earnings for the further growth of their business and new acquisitions in the market.
- In the company when there are a large number of shareholders, it will be very difficult for the company to follow the stable or fixed pattern of dividend policy. According to the pattern of earnings in the later years, the company can then decide to distribute the dividend according to certain division pattern.
- The leverage or the debts whether short term or long term also affect the dividend payout. generally the company which is highly leveraged has to pay many payments in the form of interest in which case there remains very less amount left out for the distribution of dividends.
Essentials
There are three essentials for good dividend policy:
- Distribution of Lower Dividend in the Initial Years of the Corporation of the Company: in the initial year of the corporation of the company it generally makes lower profits and earnings. So the dividend distributed in the initial stages of the formation of a company is little.
- Increase in the Distribution of Dividend: as the company grows, its profits and earnings also increases and it should increase david and distribution to gain the confidence of shareholders.
- Stability: When company attains the stable position in the market; it should follow the stable pattern of dividend distribution in order to gain the confidence of existing shareholders
Importance
- It helps in capital budgeting activities of the company and hands and the capital structure of the company gets improved.
- The shareholders of the company get an idea of the receipt of dividend in the future and hence the company gets the trust of investment by them.
- Better dividend policy shows the good financial position of the company and hence attracts investors who can leverage a good sum to it.
- It helps in good planning of future projects. the company can have an idea of its liquidity and profits.
- Good dividend policy attracts much investors as a result of which the market value of the shares get increased.
- The good policy creates a goodwill for the company and it can raise the funds in the future easily because of its goodwill
Conclusion
Dividends and Dividend policy are both the crucial factors for the company to gain the trust of shareholders and thus to increase the investments in the company. There are different types of dividend policies which include fixed/regular, stable, irregular, and no dividend policy. The policy that the company selects must align with the goal of the company with the motive of maximizing value for the shareholders of the company.
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This is a guide to the Dividend Policy. Here we also discuss the introduction to Dividend Policy and factors affect along with types and importance. You may also have a look at the following articles to learn more –
