Financial Management – II

Assignment on Factors Determining

Submitted To:
Prof. Bharat Shah
ITM Business School

Submitted By:
Ajay Garg
Roll no. 71
Dividend policy: There is a relationship between the dividend policy of a firm and total value of
the firm. There are conflicting viewpoints as dividend policy is very much make a change in the
price of the share price of firm as same that it makes change in the value of firm. Dividend
Policy involves the decision to pay out earnings or to retain them for reinvestment in the firm.
The retained earnings constitute a source of financing. The dividend policy should strike the
balance between the current dividend and future growth which maximizes the price of firms
share.

Following are the factors that affects the dividend policy of the firm:

1). Dividend Payout (D/P) Ratio: It is a major aspect of the dividend policy of a firm. This ratio
is the percentage share of the net earnings that is distributed to the shareholders as the dividend.
As taken the motive of firm is maximize the wealth, the firm D/P ratio is that it must increase in
the wealth of owners in long run. Dividend is the only source of cash flow which a owner gets
from the company. A low D/P ratio may cause a decline in share prices, while a high ratio may
lead to a rise in the market price of the shares.

2). Stability of dividend: It also affects the dividend policy of a firm. Dividend stability refers to
the lack of variability in the stream of dividends. The stability of should take any of following
three forms:

a). Constant dividend per share: according to this form of stable dividend policy, a company
paid the dividend at fix amount year after year, irrespective of the level of earnings. It does not
mean that it pays same throughout the life time, it will increase only the time it is comformed
that it can now hold that increase afterwards also.

b). Constant payout ratio: it is the policy to pay a constant percentage of net earnings as
dividend to shareholders in each dividend period. To illustrate, if a firm has a policy of D/P ratio
of say 40% then its dividends will range between 0 to 10 if EPS is taken as between 0 to Rs. 25.

c). Stable rupee dividend plus extra dividend: under this policy, a firm usually pays a fixed
dividend to shareholders and in years of market prosperity pays additional or extra dividend.

3). Legal: The dividend decision is also affected by these factors.

a). legal requirement: There are some legal stipulations that must be specified before dividend is
paid:

 Capital impairment rules: legal enactments limit the amount of cash dividends that a firm
may pay. A firm cannot pay dividends out of its paid-up capital, otherwise there would be a
reduction in the capital adversely affecting the security of its lenders.
 Net profits: A firm is not allowed to pay dividend more than its current year profit plus its
accumulating balance of retained earnings. For that section 205 of indian company act is
there to govern this statement.
4). Contractual requirements: A firm can also be bind by the contract they had entered while
taking the loan of long term. Such restrictions may cause the firm to restrict the payment of cash
dividends until a level of earnings has been achieved. Keeping in view the severity of penalty,
the financial manger has to see any contractual requirement is there or not before making any
declaration of dividend.

5). Internal constraints: Such factors are unique to a firm and include the following factors:

a). Liquid Assets: The firm has to see whether the firm has sufficient cash funds to pay cash
dividends. It may be possible that firms earnings are substantial, but the firm may be short of
funds. This situation is very common for growing companies, companies which has to retire past
loans, or companies whose preference share are to be redeemed.

b). Earning Stability: The stability of earnings also has a significant bearing on the dividend
decision of a firm. Generally, the more stable the income stream, the higher is the D/P ratio. The
financial should remember that dividends have information value. Withholding the payment of
dividends will raise the required rate of return of investors and, therefore, depress the market
price of the shares. The increase in earnings should be such that it can offset the unfavorable
effect of the increased cost of equity (Ke).

6). Owner’s consideration: The dividend is also likely to be affected by owner’s consideration.
Following are those considerations:

a). Taxes: The dividend policy is also to be made after considering the income tax statues of its
shareholder’s. If the firm has high base of owner’s who are in high tax brackets, its dividend
policy should seek to have less D/P ratio and vice versa.

b). Opportunities: The opportunities of owner’s are concerned with the comparison with the R
and Ke.. And if R > Ke than firm should maintain less D/P ratio otherwise its reverse.

c). Dilution of ownership: The financial manager should recognize that a high D/P ratio in long
term make a dilution of earnings and of control also. Because as ratio is maintain high it lacks
finance in making further expansion and to get finance, one has to issue more capital by equity
share thus reduces the control of owner’s.

7). Capital market consideration: It is also a major factor that effect dividend policy of a firm.
In case the firm has a easy access to the capital market, either because it is financially strong or
large in size, it can go for a liberal dividend policy and if firm has less access to capital market it
has to follow a tight dividend policy as its main source of finance is only retained earnings and if
payout is more than its difficult to raise more money by less accessed firm.

8). Inflation: Finally its inflation which affects the firms dividend policy. With rise in price,
funds generated from depreciation may be inadequate to replace obsolete equipments. And those
firms has to rely more on retained earnings and they will pay less as a dividend to the owner’s
and keep more with themselves.
9).Past dividend Rates: While formulating the Dividend Policy, the directors must keep in mind
the dividend paid in past years. The current rate should be around the average past rat. If it has
been abnormally increased the shares will be subjected to speculation. In a new concern, the
company should consider the dividend policy of the rival organisation.

10). Time for Payment of Dividend: When should the dividend be paid is another
consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute
dividend at a time when is least needed by the company because there are peak times as well as
lean periods of expenditure. Wise management should plan the payment of dividend in such a
manner that there is no cash outflow at a time when the undertaking is already in need of urgent
finances.

11). Taxation Policy: High taxation reduces the earnings of the companies and consequently the
rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of
dividend beyond a certain limit. It also affects the capital formation. In India, dividends beyond
10 % of paid-up capital are subject to dividend tax at 7.5 %.