Question

What is Payout policy and how do you solve for it?

Answer 1

Pay out policy generally refers to the firm's policy for distribution of earnings among the stake holders. This distribution could be either by way of dividend or by stock repurchase. While the second one, that stock repurchase is not a common and continuously repeated process, generally there will be no laid down policy for that. At the same time, Dividend is generally paid every year (sometimes during the course of the year also as interim payments) depending on profit earned and surplus available. Hence Pay out Policy mostly deals with Dividend payments, discussed in more detail below...

Dividend Policy is the policy followed by a company with respect to dividend payouts in the long run. In the case of established companies, investors can have a fair idea of the dividend income they will earn, year after year, by following the dividend policy. Generally, there are three types of policies for dividend payouts-

(1) Stable Dividend Policy; In this case, the amount of dividend per share will be stable and constant over a period of time. While this policy enables the investor to anticipate his dividend income with a fair degree of certainty, this suffers from the lack of possibility of higher payouts in the years of better profits.

(2) Constant Dividend Policy: Companies following this type of Dividend Policy pay a definite percentage of their earnings every year. The amount of payout may vary according to amount of profit earned each year. While this policy allows higher dividend income for the stakeholders in the good times of the company (of course, with the probability of lower income in bad times), it suffers from the lack of certainty for the investors with respect to the current income, especially the long term investors.

(3) Residual Dividend Policy: Under this policy, dividend is paid only out of the surplus profit, after setting apart amount required for capital expenditure and working capital. While this policy denies the comfort of certainty of periodical income for the investors, some hail it as progressive for capital appreciation. Because, this policy puts the growth plans of the company ahead of individual investors' immediate income concerns. Such a strategy will be beneficial for the investors in the long run, as they can reap the benefits of companies growth after some time.