Question

Describe the possible and common effects on dividend-payout ratios for the below:

1. Interest rates increase significantly;
2. Company profitability grows;
3. Prospectus requirements are tightened, leading to an increase in the cost of share issue;
4. Personal income (but not capital gains) tax are increased;

Answer 1

a) If the interest rate rises significantly then the cost of sources of funds will go up and the company would like to retain more earnings in order to meet the future capital expenditure requirement so the dividend payout ratio will reduce. Higher retained earnings mean lower payout ratio.

b) If the company profitability grows then the company has more funds at its disposal and the company can consider paying more dividends so here the probability is high that with rise in profitability the dividend payout ratio will increase.

c) Here when the cost of issuing share is high that means the required rate has gone up in these circumstances most companies avoid raising external sources of funds and if the company has funds or profits it would choose to retain more profits in order to avoid the high cost of raising funds so the dividend payout ratio will most likely decrease.

d) In most countries dividend is treated as income where as gain on price is treated as capital gain and personal income or income is treated at higher rates and capital gain is treated at lower rates so most investor prefer capital gain when the income tax is high in order to reduce the tax liability so if the personal income tax increases then the companies might reduces the dividend payout ratio.