Effect Of Formulation Of Dividend Policy.docx

John Emmanuel A. Laceda

Effect of Formulation of Dividend policy Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will pay out to shareholders. Some evidence suggests that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an issuance of dividends should have little to no impact on stock price.

TYPES OF DIVIDEND POLICY Residual Dividend policy Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met

Dividend stability policy With the stability policy, quarterly dividends are set at a fraction of yearly earnings. This policy reduces uncertainty for investors and provides them with income

Hybrid dividend policy In today's markets, this approach is commonly used by companies that pay dividends. As these companies will generally experience business cycle fluctuations, they will generally have one set dividend, which is set as a relatively small portion of yearly income and can be easily maintained. On top of this set dividend, these companies will offer another extra dividend paid only when income exceeds general levels.

EFFECTS OF FORMULATION OF DIVIDEND POLICY Formulation of dividend policy for a business enterprise calls for careful consideration of factors which may be categorized into external and internal considerations.

External Considerations 1. General state of Economy: Level of business activity of an enterprise and so also its earnings is subject to general economic and business conditions of the country. Uncertainty about future economic and business conditions may lead 0 to retention of all or part of the profits in the company. During the periods of prosperity the management may not always be liberal in dividend payment although earning power of the company warrants. 2. State of capital market: If the state of capital market is relatively comfortable and raising funds from different sources, the management may tempt to declare high dividends. In case of slump in capital market, the situation will be completely different. 3. State regulation: The management must formulate the dividend policy within the overall legal frame work which may prescribe rules to regulate pattern and mode of income distribution. 4. Tax policy: Dividend policy is also affected in part by tax policy of the Government. Tax incentives may lead to liberal dividend policy.

Internal Considerations 1. Company’s investment opportunities and stockholders’ preferences: Appropriate dividend policy of a company is one that is designed in the light of the company’s investment opportunities and stockholders preferences. The company has to give importance to the stock holder’s preferences. 2. Nature of company’s Business: Nature of business activity of the company influences largely the level of income. A company with fluctuating earnings must retain larger share of income during boom periods so as to ensure that dividend policy is not affected by the business cycle. 3. Access to capital market: A company which is access to capital market can raise funds and earn reasonable profits and can formulate liberal dividend policy. 4. Age of company: An old and established company having reached saturation point may follow a high pay out policy, where as young and growing concern cannot follow, it, as it requires large amount of funds to finance its growth requirements. 5. Growth rate of company: A rapidly growing concern requires long-term funds. Hence its dividend must be kept at a minimum. 6. Liquidity position of company and its funds requirements: A company with high profitability and large reserves may not necessarily have sufficient cash balances to pay cash dividends particularly when most of the sales has been affected through credit, in such a situation it would be unwise to drain off additional cash by paying dividends. 7. Repayment of debt: If the company wants to repay the debt, it has to follow conserve dividend policy. 8. Ownership of company: In a closely held company with a few but affluent stock holders, the management will always retain larger share of the profits so as to reduce tax liability of the stockholders.

9. Restrictions in debt agreements: In case the company is indebted with long-term debt the financial manager must examine carefully the provisions of debt agreements and decide about dividend payments accordingly. 10. Control: Control is also an important factor that influences the pattern of income distribution. The issue of additional common stock for procuring funds dilutes control to the detriment of the existing stock holders who have dominating voice in the company.