Question

Dividend Policy

a. What drives a firm’s dividend policy?
b. What are the two major forms of dividend distributions to shareholders?
c. How do the two forms differ (why would one would be preferred over the other)? d. How do you calculate the estimated dividend and payout ratio for a firm using the residual distribution model.

Answer 1

Answer(a): Firm's dividend policy- Company works for profit, when it generates profit, it distributes to the shareholders in the form of dividend. Dividend is paid on the face value of the stock.

Drivers of dividend policy- These are the factors that drive a firm's dividend policy-

Earnings- If a company gets profits then only it can distribute dividend, in case of loss, it cannot pay dividend. If earnings are increasing year on year, dividend will also increase.

Enough liquidity- If a company has enough liquidity then only it can pay cash dividend. If lack of cash is there, cash dividend cannot be paid.

Debt obligation- If company is having higher debt then it has to pay higher interest out of the profit hence profit for shareholders will be very less to pay the dividend.

Answer(b): Forms of dividend distributions to shareholders-

Cash dividend- It is paid in cash. A percentage of profit is kept aside for distributing dividend and cash dividend paid on the face value of the share, dividend is directly credited to investor's account. Cash dividend can be paid quarterly, half yearly or annually based on earnings of company.

Stock dividend- If company does not have enough cash to pay dividend, it will pay the dividend in form of shares. It will give some shares to the shareholders in the form of dividend.

Answer(c): Two forms of dividend differ because they are based on the liquidity of the company. If a company has enough liquidity, it will pay cash dividend otherwise it will pay stock dividend.

Answer(d): Residual dividend model- This model is adopted by companies that prioritize capital expenditure over the shareholders dividend payment. These companies invest into growth opportunities so that dividend can be paid to shareholders.

Company needs to follow some steps in this policy:

• Firstly identify the capital budget.
• Determine the amount of equity that is needed.
• Meet th4e equity requirement with the retained earning.
• Pay dividends out of the residual earnings.