Question

Please explain why some companies in the capital market tend to adopt a high dividend policy, while others prefer a low dividend policy based on dividend policy theories. And indicate elements companies should consider when determining dividend policy.

Answer 1

A dividend policy is a company's approach to distributing profits back to its owners or stockholders. If a company is in a growth mode, it may decide that it will not pay dividends, but rather re-invest its profits (retained earnings) in the business. If a company does decide to pay dividends, it must then decide how often to do so, and at what rate. Large, well-established companies often pay dividends on a fixed schedule, but sometimes they also declare `special dividends'. The payment of dividends impacts the perception of a company in financial markets, and it may also have a direct impact on its stock price

Some companies in the capital market tend to adopt a high dividend policy, while others prefer a low dividend policy because of the following reasons:

· Lack of investment opportunities. If businesses cannot identify a project that provides an adequate return on capital, then they are better off returning cash to shareholders. Corporate finance theory would suggest this is good.

· Higher dividends tend to decrease an agency’s costs. This occurs because the more dividends management needs to pay out, the more external financing the firm will require. External financing increases the scrutiny that management actions have to undergo and, therefore, decreases the agency problem and agency costs.

· Paying high dividends sends a clear, powerful message about a company's future prospects and performance, and its willingness and ability to pay steady dividends over time provides a solid demonstration of financial strength

· One of the simplest ways for companies to foster goodwill among their shareholders, drive demand for the stock, and communicate financial well-being and shareholder value is through paying high dividends

· Investors also see a high dividend payment as a sign of a company's strength and a sign that management has positive expectations for future earnings, which again makes the stock more attractive. A greater demand for a company's stock will increase its price.

Following are the elements that a companies should consider when determining dividend policy

1. Cash Needs of a Company

Cash position is a big criterion to pay dividend. For a company, cash is needed for various con­tingencies. They cannot be ignored for the survival of a com­pany. So, dividend policy has to be made after a serious consid­eration of the cash position of the company.

2. Need for Growth and Expansion

A company, quite likely, is brought into being not to remain static. It is to grow and ex­pand. For this, cash flow must exist. Every available amount cannot be spent for payment as dividend to shareholders. That will restrict the scope for its growth and expansion.

3. Government Taxation Policy

In these days corporate taxation is a very important factor to take into consideration. Government levies huge amount of taxes on companies to augment its revenue needs. This means the management is put into difficul­ty in maintaining stable or high rate of dividend. So, this has to be considered while formulating dividend policy.

4. Better Investment opportunity

Another factor that can influence management's dividend policies is the potential for better returns through capital reinvestment. In other words, if a company feels that it would be in the best interest of its shareholders to use its profits for other business activities besides paying dividends, it could choose not to pay – even if its revenues are stable and predictable.

5. Economic conditions
Another major factor that influences dividend policies is the market environment. If a certain sector is having trouble and anticipates profits falling, it's common for companies to get quite defensive when it comes to their dividends. This can be seen currently in the energy sector, where low oil prices have wreaked havoc on many companies' profitability, which has led to several major companies slashing their dividends recently.

6. Income stability

Income stability is one of the top factors in determining dividend policies. Specifically, established companies with stable, predictable income streams are more likely to pay dividends than companies with growing or volatile income. Newer and rapidly growing companies rarely pay dividends, as they prefer to invest their profits back into the company to fuel even more future growth. And, companies with unstable revenue streams often choose not to pay dividends, or pay small dividends in order to make sure the payout will be sustainable.