Another set of factors that can influence dividend policy relates to the firm growth prospects. The firm is required to make plans for financing its expansion programmed this context, the availability of external funds and its associated cost together with the need investment funds would have a significant bearing on the firm’s dividend policy.
Financial requirements of a firm are directly related to its investment needs. The firm should formulate its dividends policy on the basis of its foreseeable investment needs. If a firm has abundant investment opportunities, it should prefer a low payout ratio, as it can usually reinvest earnings at a higher rate than the shareholders can. Such firms, designated as growth companies, are constantly in need of funds. Their financial requirements may be characterized as large and immediate. That retention of earnings is less costly than selling a new issue of equity needs no reiteration. Moreover, retention of earnings provides the base upon which the firm can borrow additional funds. Therefore, it provides flexibility in the company’s capital structure, that is, it make room for unused under capacity. The importance of creation of debt raising potentials for a growing firm is overwhelming.
On the other hand, if the firm has little or no growth opportunities, it will probably prefer low retention and relatively high dividend payouts. This is so for two vital reasons. First, the shareholders can reinvest earnings at a higher rate than the firm can do, and, secondly, such firms may need funds largely co replace or modernize assets. In many instances, these outlays may not be required immediately but after two or three years. Therefore, the need for funds is small and periodic vis-a-vis large and fast growing companies. The nature of the firm’s needs, therefore, is an important factor in determining the destination of the firm’s fund-retention or distribution.