Question

Shareholders expect companies to distribute their profits through dividends. Is the payment of dividends as simple as this? Describe and evaluate the approaches and considerations that companies take into account before choosing to pay out their profits as dividends to shareholders.

Answer in around 700 words

Answer 1

What Is a Dividend?

A dividend, also known as distribution, is a portion of a company’s profits that is paid to the shareholders, based upon the number of shares held in the company. Dividend is an essential component both for the investor and the company that serves multiple purposes to them.

Most Common types of Dividends

· Cash Dividend

· Stock Dividend

· Property Dividend

· Scrip Dividend

· Liquidating Dividend

Why Companies prefer to Pay Dividends.?

Shareholders expect the companies that they invest in to return profits to them in terms of Dividend, but not all companies pay dividends.

Some companies keep profits as retained earnings that are earmarked for re-investment in the company and for its growth prospects.

• Reflection of Company’s financial stability

Companies that distribute regular dividends over a long period of time are considered as more stable. Even if the company runs into current financial distress, by continuing to pay dividends, it wins investors’ trust that it still remains its positive future prospects and outlooks the current financial situation.

• Dividends Attract More Investors

Dividends can be expected by the shareholders as a reward for their trust in a company. Dividend payments reflect positively on a company and help maintain investors’ trust. Psychologically positive sentiments are attained from investors for Dividend Paying Companies. High dividend payout is important for such investors to maintain the demand of the stock in market and hence keeps its price high.

If a company has a long history of dividend payments, a reduction of the dividend amount, or its elimination, may signal to investors that the company is in trouble. The announcement of a 50% decrease in dividends from General Electric Co. (GE), one of the biggest American industrial companies, led to a decline of more than six percent in GE’s stock price in November, 2017.

It can be a sturdy decision to evaluate whether to spend some of the company’s profits to pay dividend to shareholders or retain it for future.

Following factors greatly influence the decision for dividend payment.

• Economic Conditions

Before distributing the dividends, it is necessary to evaluate if there are uncertain economic and business conditions like depression or high inflation. More dividends can be paid out in times of prosperity since there are large profitable investment opportunities.

• Capital Market Considerations

This also affects the dividend policy to the extent to which the firm has access to the capital market. In other words, if easy access to the capital market is possible whether due to financially strong or, big in size, the firm in that case, may adopt a liberal dividend policy.

• Tax Consideration          

Dividends increase the taxable income of shareholders. The tax policy which is followed be a Government also affects the dividend policy of a firm. The decision of choosing the method of paying dividend depends to some extent on the tax policy.

• Legal, Contractual Constraints and Restrictions:

This is one of the most significant factors while considering dividend policy of a firm since it has to be evolved within the legal framework and restrictions. It is not legally binding on the part of the directors to declare dividends. Contractual restrictions, on the other hand, which are imposed by certain lenders of the firm, also affect the dividend policy of a firm. Because, they impose certain conditions about the payment of dividend particularly, during the period when the firm is experiencing liquidity or profitability crisis.

• Dividend Pay-Out (D/P) Ratio:

Dividend Pay-out (D/P) ratio (i.e., percentage share of the net earnings/profits distributed to the shareholders by way of dividends) also affects the dividend policy of a firm. It involves the decisions either to pay out the earnings or to retain the same for re-investment within the firm.             

• Growth Factors

Dividends reduce the amount of equity a company can invest in other operations. The board must decide what new or existing projects would benefit from the cash used for payouts and whether those projects would increase the company’s return on equity. If it pays dividends instead of funding profitable investments the investments should return an amount greater than company’s weighted average cost of capital. When investments grow the company, the stock usually appreciates.

• Liquidity Position

While deciding the dividend policy, the liquidity aspect should also be considered. Because, if dividend is paid in cash, there is an outflow of cash. A firm may have an adequate income/profit but it may not have sufficient cash to pay dividend.