A) Discuss the relevance of dividend policy in financial decision making?

Dividend policy is a set of guidelines a company uses to decide how much of its earnings it
will pay out to shareholders . Financial decision making is concerned with the borrowing and
allocation of funds required for the investment decisions .financial managers uses the
dividend policy technique to implement decisions on wealth maximization , reducing agency
cost , long term financing decision and so on.

Wealth maximization
Due to market imperfections and uncertainty , shareholders give higher value to near
dividends then future dividends and capital gains payment of dividends influences the market
price of the share ,higher dividends increase value of shares low dividends decreases it. A
proper balance has to be struck between the approaches .When the firm increases retained
earnings shareholders dividend decrease and consequently market price is affected .use of
retained earnings to finance profitable investment increases future earnings per share.

Long term financing decision

When dividend is treated as a financing decision , net earnings are viewed as a source of long
term financing .Payment of cash reduces the amount of funds necessary to finance profitable
investment opportunities .Thus earnings may be retained as part of long term financing
decision while dividends paid are distributions of earnings that cannot be profitably
reinvested .

Reducing agency cost

Since Jensen and Meckling (1976), many studies have provided arguments that link agency
costs with other financial activities of the firm. It has been argued that firms payout
dividends in order to reduce agency costs. Dividend payout keeps firms in the market where
monitoring of managers at a lower costs. If a firm has free cash (Jenson1986), it is better off
sharing them with stockholders as dividend payout in order to reduce the possibility of these
funds being wasted on unprofitable projects.

Resolution Uncertainty
 Investors are always cautious about the future ,particularly under uncertainty .They therefore
are more interested in short run income which is more certain and assured than in the long
run earnings which is unpredictable .Since dividend reduces uncertainty about the level of
earnings for the investor, stockholders may give greater weight to expectations concerning
present dividends than to beliefs as to what the trend in price and dividend might be in the
long run. Furthermore present value of income received in short run is higher than the present
value of future earnings. In view of this, stockholders can never remain neutral between
dividend and capital gains.

Future Prospects
Dividend policy is a financing decision and leads to cash outflows and also leads to available
of cash for financing of profitable projects. If sufficient funds are not available, a firm has to
depend on external financing. Therefore the dividends policy needs to be devised in such a
manner that prospective projects may be financed through retained earnings.

b)State and explain 5 factors that affect dividend policy (15)

Dividend policy means formation of policy by the company regarding the payment of dividend
from profits to ordinary shareholders year to year. It determines the ratio between dividend and
retained earnings. Then what type of dividend policy do firms adopt? Whether it is 20 per cent,
or 40 per cent or 80 per cent or any other percentage of earnings available to shareholders. The
policy relating to dividend pay-out ratio and earnings retention varies not only from industry to
industry but also among companies within a given industry and within a company from time to
time. These variations are because of factors influencingdividend policy which includes:

Nature of Earnings
The nature of business has an important bearing on the dividend policy. The industrial units that
are having stability of earnings may formulate stable or a more consistent dividend policy than
other that are having variations in earnings, because they can predict easily their earnings. Firms
that are involved in necessities suffer less from stable incomes than the firms that are involved in
luxury goods. The industries/firms that are having stable earnings can adopt stable or high
dividend policy, while the other firms that are having variations in earnings should follow a
variable or low dividend policy.

Age of Company

The age of company has more impact on distribution of profits as dividends. A newly started and
growing company may require much of its earnings for financing expansion programs or growth
requirements and it may follow rigid dividend policy, wherein most of the earnings are retained.
On the other hand, an old company with good track record and good name in the public can
formulate a clear cut and more consistent dividend policy. This type of companies may even pay
100 per cent dividend pay out ratio and the required amount for growth can be raised from
public.

Liquidity position of the company

Generally, dividends are paid in the form of cash, hence it entails cash. Although, a firm may
have sufficient profits to declare dividends, it may not have sufficient cash to pay dividends.
Thus, availability of cash and sound financial position of the firm are an important factor in
taking dividend decision. The liquidity of a company depends very much on the investment and
financial decisions of a firm, while in turn determining the rate of expansion and the manner of
financing. If cash position of a firm is weak, stock dividend will be better and if cash position is
good it can go for payment of dividend by cash.

Control Objective

Control on the company is also an important factor, which influences dividend policy. When a
firm distributes more earnings as dividends in the form of cash it reduces its cash position. As a
result, the firm will have to issue shares to the public to raise funds required to finance
investment opportunities that leads to loss of control, since, the existing shareholders will have to
share control with new owners. Financing investment projects by way of internal source avoids
loss of control. Hence, if the shareholders and management of the firms are reluctant to dilution
of control, thus the firm should retain more earnings for investment programs , by following a
conservative dividend policy.

Legal Rules

Legal rules are significant as they provide framework within which dividend policy is
formulated. In other words, dividend policy of a firm has to be evolved within the legal
framework and rules and regulations. The legal rules have to do with capital impairment rule, net
profits and insolvency rule.

 Capital Impairment Rule:

First these provisions require that the dividend can be paid from earnings either from current
year earnings or from past years’ earnings and reflected in the earned surplus. If firm pays
dividend out of capital that adversely affects the security of its lenders. The purpose of this rule
is to protect creditors (preference shareholders and auditors of the firm) by providing sufficient
equity base because they have originally relied on that base. Therefore, the financial manager
should keep in mind the legal rules while declaring dividends.

 Net Profits:

This rule is essentially a result of the earlier rule. A firm can pay cash dividends within the limits
of current profits plus accumulated balance of retained earnings. A firm can take profits of past
years if the current year’s profits are not sufficient to maintain stable dividend policy. If there are
any losses that are carried forward, they should be set off from the current year’s earnings before
declaration of dividends. So financial manager within the boundaries, at the same time, has to
consider many financial variables and constraints in deciding the amount that is paid as
dividends.

 Insolvency Rule:

A firm is said to be insolvent in two cases. One, in a legal sense, the recorded value of liabilities
exceeding the recorded value of assets, or second, as in a technical sense, as the firm’s inability
to pay its creditors as obligations come due. If the firm is insolvent in either sense, it is
prohibited from the payment of dividends. The rationale of this rule is to protect the creditors.
REFERENCE LIST

Jensen Micheal. C. and William Meckling , ‘theory of the firm : Managerial Behavior , Agency
Costs and Ownership Structure ‘journal of Financial Economics , vol .3.1976, p.305-60.

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