Question

1. Do investors generally prefer dividends or share repurchases? Support your answer.

2. What are some considerations a company should take into account when establishing dividend policy?

Answer 1

Answer 1:

Dividend is the part of profit of the Company which is paid to its shareholders as a return on their investment. Dividend is paid to shareholders at a regular intervals, from the after-tax profit and investors are required to pay tax on the dividend.

Share repurchase is also known as buyback of shares in which a company buy backs shares from the market, resulting in reduction in the number of outstanding shares, which can rise the price of shares over the period of time.

Both dividend and buyback can significantly increase the shareholders rate of return. The main difference between the two is that dividend payments represent a definite return in the current timeframe that will be taxed, on the other hand, share repurchase represents an uncertain future return on which tax is deferred until the shares are sold.

Investors generally prefer share repurchases over dividends due to the following reasons:

1. Investors are required to pay tax on the dividend received by them. But the tax in case of share repurchase is only paid when such shares are sold. Hence if the shares are held for more than one year, the gains would be subjected to a lower capital gains rate.

2. Share repurchase increases the shareholders value. Reducing the number of outstanding shares and maintaining the same level of profitability, Earnings per share will increase. Therefore, for the investors who do not sell their shares, will now have a higher percentage of ownership and higher price per share.

3. Shares repurchase also results in rise in shares price. When earnings per share increases, the market will perceive this positively and share prices will also increase. It also reflect the demand and supply law. When there is less available supply of shares then an upward demand will rise the share prices.

4. For share repurchase, company uses it excess cash on hand, hence the investors do not need to worry about the utilisation of cash since it indicates that the company feels cash is better used to reimburse shareholders than reinvent in alternative assets

Hence due to the above reasons Invertors prefer share repurchases over dividends.

Answer 2:

The following are the points company should consider while establishing divided policy:

1. The dividend policy depends upon the economic conditions. It helps to decide whether dividend should be retained or the same should be distributed among the shareholders. For example, if there is depression in the economy, the management may withhold the dividend payment or if there is prosperity, the dividend will be paid to shareholders due to large profitability.

2. Company should also take into account the capital markets consideration. If company has easy access to capital market, it may adopt liberal divided policy. In the opposite case, it may adopt conservative dividend policy.

3. The company should consider the legal framework for declaring the dividend. It is because dividend has to be evolved within the legal framework and restrictions. All the requirements and restrictions should be considered by the company while deciding the dividend policy.

4. Another thing which affects dividend policy is tax policy. Whether it is better to declare and pay dividend in cash or by the issue of bonus shares, depends to some extent on the tax policy. Because some investors do not consider cash dividend attractive due to tax brackets.

5. Inflation may also affect dividend policy. Due to rise in price, funds that are generated through depression may fall short in order to replace obsolete equipment. The short fall may be made from retained earnings. It is very important when the assets are to be replaced in the near future. As such, the dividend pay-out ratio tends to be low during inflation.

6. Even though dividend depend upon the profit of the company, shareholders appreciate a certain amount of dividend every year. Hence the company should take into account the stability of dividend. Stability in dividend helps in resolution of investors uncertainty, raising additional finance, etc.

7. Dividend policy depends on the dividend pay out ratio. It involves the decisions either to pay out the earnings or to retain the same for reinvestment with the firm.

8. Owners consideration should also be taken into account. The company should consider their opportunity of investment and also the dilution of ownership.

9. Nature of the earnings also helps in deciding the dividend policy. For example, if the profit of the company is stable then in this case the company can not afford to pay higher dividend to shareholders.

10. While deciding the dividend policy, company's liquidity position should also be considered. Because, if the company pays dividends in cash, then the company needs the cash in hand for the payment of dividend.

Hence these are the things that should be considered by the company while establishing dividend policy.