Question

1. Define target payout ratio and optimal dividend policy?

Answer 1

What is the Target Payout Ratio

A target payout ratio is a measure of the percentage of a company's earnings it would like to pay out to shareholders as dividends over the long-term. Firms are conservative in setting their target dividend payout ratio with the goal of being able to maintain a stable dividend level while also retaining enough capital to grow and/or operate the business efficiently.

Sometimes the payout ratio is equal to the target payout ratio. Other times the payout ratio—which is dividends per share divided by earnings per share—may be higher or lower than the target rate because earnings fluctuate from quarter to quarter and year to year.

KEY TAKEAWAYS

• Target payout ratio is the payout ratio the company would like to achieve over the long-term.
• The payout ratio may differ from the target payout ratio as earnings fluctuate over time. This is why the target is typically a long-term goal or average over a longer period of time.
• Changes in dividend policy can have significant effects on stock prices and investor perception. Companies will often provide advance guidance on how dividends will look in the future and what their target payout ratio is.

optimal dividend policy

Once a company makes a profit, management must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends.

Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.

There are various theories that try to explain the relationship of a firm’s dividend policy and common stock value.

Dividend Irrelevance Theory

This theory purports that a firm’s dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.

Optimal Dividend Policy

Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm’s stock price.

Dividend Relevance Theory

The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm’s value.