Question

3. You are the CFO of a company that is contemplating issuing dividends for the first time. Discuss, in as much detail you can, at least six issues you must consider when you structure a company’s dividend policy. Please structure your answer according to the theories and discussion in your text. (No more than 4 pages).

Answer 1

Growth factors and business cycle

Since dividends are given out from the retained earnings which is, in turn, is from the profits that the company had produced. The key consideration in this front is to access whether the company would benefit more from the cash to invest in projects or should the company use this cash to payout the shareholders and increase the return on equity. There should an acceptable tradeoff between increasing ROE by giving out dividends and investing in more profitable projects for the company to expand. Investing in profitable projects would enable the company to grow, thus giving capital gains for the shareholders as the stock price generally increases as the profitability increases. Also, the sector the company is in might have a characteristic business cycle of boom and bust. During a boom, a company must build its buffer as when times are bad, the adverse situation may not be as adverse for the company.

Cost considerations

Cost considerations refer to the company's decisions and view on the capital and cost structure. A company can either give out dividends or can use the excess cash to bring down the debt or using for any other restructuring purposes. A company also might use excess cash to acquire another firm in order to boost the company's top and bottom line. In short, the firm can compromise on the dividend payment for the betterment of the long-term financials of the company, which in turn increases the firm's ability to generate profits in the future.

Retained earnings

The cash dividends come out of retained earnings, which is accumulated from the profits of a company. In case, the company has substantial debt, creditors may impose restrictions on retained earnings, which will eventually limit the amount of dividends.

Tax considerations

Tax is an important consideration because dividends increase the taxable income of shareholders. Due to this, some shareholders might prefer that the company buy back shares from the market instead of giving out dividends since buyback has tax benefits as compared to dividends.

Type of industry the company operates in

The industry sector of the company is an important consideration when it comes to dividend policy. An industry sector that has high cash-flows generating capacity and has stable income has a dividend policy more consistent and well-defined. This is because earnings stability ensures that a consistent dividend amount can be paid. On the other hand, if the earnings are volatile, this may result in abnormal or inconsistent dividend, as the amount of excess cash generated, would be subject to fluctuations

Ownership structure

An ownership structure of a company with a higher promotor share would demand a lesser dividend income. This is because the promotors are concerned with the growth of the company and do not hold the stocks for investment purposes. On the other hand, a company with higher institutional investor demand a higher dividend payout.

Leverage of the company

A company with higher leverage. ie. higher debt would have higher interest costs and a lot of cash-flows would be spent on serving the interest payments of these debts. Hence, a highly leveraged firm would have fewer dividend payouts, because such companies need to have enough capital as a cushion to make the interest payments on the debt.