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Explain the Factors Affecting the Dividend Decision. - Business Studies

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ConceptFinancial Decisions - Financing and Dividend

Question

Explain the factors affecting the dividend decision.

Solution

Dividend decision of a company deals with what portion of the profits is to be distributed as dividends between the shareholders and what portion is to be kept as retained earnings. The following are the factors that affect the dividend decision.

1. Amount of Earning :- A firm pays dividends out of its current and the past earnings. This implies that earnings play a key role in the dividend decision. A company having higher earnings will be in a position to pay a higher amount of dividend to its shareholders. In contrast to this, a company having low or limited earnings would distribute low dividends.

2. Stable Earnings :- When a company has a stable and a smooth earning, they are in a position to distribute higher dividend as compared to the companies who have an unstable earning. In other words, a company having consistent and stable earnings can distribute higher amount of dividends.

3. Stable Dividends :- Companies generally follow the practice of stabilising their dividends. They try to avoid frequent fluctuations in dividend per share and opt for increasing (or decreasing) the value only when there is a consistent rise (or fall) in the earnings of the company.

4. Growth Prospects :- Companies aiming for a higher growth level or expansion of operations retain a higher portion of the earnings with itself for re-investment. Thus, dividend of such a company is smaller as compared to the companies with lower growth opportunities.

5. Cash Flow Position :- Dividend payments require cash outflow. If a company is low on cash then the dividend will be lower as compared to the company which has more liquidity. Even if a company has higher profits, it will not be able to distribute high dividends if it does not have enough cash.

6. Preference of the Shareholders :- A company must keep in mind the preferences of the share holders while distributing the dividends. For instance, if the share holders prefer at least a certain amount of dividend, then the company is likely to declare the same.

7. Taxation Policy :- Taxation policy plays an important role in deciding the dividends. If the taxation policy is such that a high rate of tax is levied on dividend distribution, then the companies are likely to distribute lower dividends. On the other, it might prefer to distribute higher dividends if the tax rate is low.

8. Stock Market Reactions :- The amount of dividend that a company distributes affects its stock market prices. An increase in dividend by a company is viewed as a good sign by the investors and the stock price of the company goes up. On the other hand, a fall in the dividends adversely affects the stock prices. Thus, while taking the dividend decision, a company must consider the probable stock market reactions.

9. Contractual Constraints :- Sometimes, while giving out loans to a company, the lender may impose some restrictions in the form of agreement. These restrictions may be related to the dividend paid in the future. In such cases, the company has to keep such agreements in mind when distributing the dividends.

10. Access to Capital Market :- The companies that have a greater access to the capital market tend to pay higher dividends. This is because they can rely less on retained earnings and more on other sources due to the market access. The smaller companies who have lower access to capital markets tend to pay lower dividends.

11. Legal Constraints :- Companies have to adhere to the rules and policies laid out by the Companies Act. Thus, any company needs to take care of such restrictions and policies before declaring the dividends.

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Solution Explain the Factors Affecting the Dividend Decision. Concept: Financial Decisions - Financing and Dividend.
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