Question

Critically discuss the trade-off between paying dividends and retaining firm profit. (300-500 words) please write in your own writing and no copying from internet.

Answer 1

Dividend policy means the practice that management follows in making dividend payout decisions, or in other words, the size and pattern of cash distributions over the time to shareholders. In other words, dividend policy is the firm's plan of action to be followed when dividend decisions are made. It is the decision about how much of earnings to pay out as dividends versus retaining and reinvesting earnings in the firm. There is a reciprocal relationship between retained earnings and dividend i.e. larger the retained earnings, lesser the dividend and smaller the retained earnings, larger the dividend.

Risk-return tradeoff is a specific trading principle related to the inverse relationship between investment risk and investment. There are no tax differences to investors between dividends and capital gains. Dividend refers to a reward, cash or otherwise, that a company gives to its shareholders. Dividends can be issued in various forms, such as cash payment, stocks or any other form. A company's dividend is decided by its board of directors and it requires the shareholders' approval. The portion of net profit distributed to shareholders is called dividend and the remaining portion of the profit is called retained earnings. In other words, the amount of undistributed profit which is available for investment is called retained earnings. Retained earning is considered an internal source of long-term financing and it is a part of shareholders equity. Generally, retained earning is considered as a cost-free source of financing. It is because neither dividend nor interest is payable on retained profit. However, this statement is not true. Shareholders of the company that retains more profit expect more income in the future than the shareholders of the company that pays more dividend and retains less profit. Therefore, there is an opportunity cost of retained earnings. In other words, retained earning is not a cost-free source of financing. The cost of retained earnings must be at least equal to shareholders rate of return on re-investment of dividend paid by the company. This is the tradeoff between paying dividends and retaining profits within the company The dividend policy decision is a trade-off between retaining earnings.