The factors determining the dividend policy of a firm may, for purpose of exposition, be classified into: (a) Dividend payout (D/P) ratio, (b) Stability of dividends, (c) Legal, contractual and internal constraints and restrictions, (d) Owner’s considerations, (e) Capital market considerations, and (f) Inflation.
Dividend Payout (DP) Ratio
A major aspect of the dividend policy of a firm is it dividend payout (D/P) ratio, that is, the percentage share of the net earnings distributed to the shareholders as dividends. The relevance of the D/P ratio, as a determinant of the dividend policy of a firm, has been examined at some length in the preceding chapter. It is briefly recapitulated here.
Dividend policy involves the decision to payout earnings or to retain them for reinvestment in the firm, the retained earnings constitute a source of financing. The payment of dividends results in the reduction of cash and, therefore, in a depletion of total assets. In order to maintain the asset level as well as to finance investment opportunities. The firm must obtain funds from the issue of additional equity or debt. If the firm is unable to raise external funds, its growth would be affected. Thus, dividends imply outflow of cash and lower future growth. In other words, the dividend policy of the firm affects both the shareholders wealth and the long term growth of the firm. The optimal dividend policy should strike the balance between current dividends and future growth which maximizes the price of the firm’s shares. The D/P ratio of a firm should be determined with reference to two basic objectives maximizing the wealth of the firm’s owners and providing sufficient funds to finance growth. These objectives are not mutually exclusive, but interrelated.
Given the objective of wealth maximization, the firm’s dividend policy (D/P ratio) should be one which can maximize the wealth of its owners in the long term. In theory, it can be expected that the shareholders take into account the long run effects of D/P ratio, that is, if the firm is paying low dividends and having high retention, they recognize the element of growth in the level of future earnings of the firm. However, in practice, they have a clear cut preference for dividends because of uncertainty and imperfect capital markets. The payment of dividends can therefore, be expected to affect the price of shares: a low D/P ratio may cause a decline in shale prices, while a high ratio may lead to a rise in the market price of the shares.
Making a sufficient provision for financing growth can be considered a secondary objective dividend policy. Without adequate funds to implement acceptable projects, the objective of weal maximization cannot be achieved. The firm must forecast its future needs for funds, and raking In account the external availability of funds and certain market considerations, determine both amount of retained earnings needed and the amount of retained available after minimum dividends bare been paid. Thus, dividend payments should not be viewed as rather a required outlay after which any remaining funds can be reinvested in the firm.