Question

What factors does a business take into account when making dividend decisions? Describe different types of dividend policy.  Based on the value of stocks using the Gordon Model or Constant Dividend Growth Model, how do dividend payments effect stock prices? What are some of the potential problems that may arise from these decisions?

Answer 1

Factors affecting dividend decision:-

1. Growth and profitability of the firm:- The firms with strong growth and profitability maintain low payout ratios because these firms focus on high retention ratios.
2. Liquidity:- Liquidity often plays an important role because better the liquidity position of the firm better will be firms ability to pay cash dividend.
3. Cost of financing:- If the cost of financing is low, financing dividend is easy
4. Managerial control:-Managers prefer low payout ratio because it will reduce the likelihood of offering of an equity to avoid dilution of control
5. Legal Implications:- Legal constraints in distribution of dividend are to checked before deciding dividend policy.

Three types of dividend policy are:-

1. Stable dividend policy:- This is the most preferred method for investors who are risk averse. As per this policy investors will continue to receive dividend no matter whether earnings will go up or down.
2. Constant dividend policy:-Under this policy company pays a percentage of earnings every year therefore in the boom period investors may get higher return
3. Residual dividend policy:-As per this policy company will pay dividend what remains after company has paid for working capital and capital expenditure

Effect of dividend on stock prices:-

When company has constant dividend policy, it becomes more attractive to investors. More and more investors try to take benefit of this policy and therefore stock price increases naturally. On the other hand, when a company pays dividend, or issues no dividend or lower rate of dividend, it may create a false impression in the minds of investors that company is facing hard times but actually it may be the fact that company has used its profit for expansion of the company.

Some of the potential problems that may arise due to the dividend decisions

1. Variability in dividend payment may create a false impression in the minds of unstable earnings of the company. Investors expect some predictable cash flow and if company cuts a dividend it leaves false impression that company is experiencing hard times when infact the future prospects is very good.

2. High dividend may affect the liquidity position of the company.This is because large amount of cash may be spent in distribution of cash dividend.