Factors in Establishing Company Dividend Policy, Research Paper Example

Introduction

This paper focuses upon those factors that are important for a company when establishing its dividend policy. The advantages and disadvantages of these factors and whether the dividend policy makes any difference to the financial viability of the company. Traditional concepts have implied that the decision to pay a dividend rests at the discretion of the Board of Directors. Key to this decision is the liquidity and cash flow of the firm. As such the amount of dividends that a Company can afford to pay will be directly related to the liquidity position of that Company. Even though a company may be ultimately profitable; nevertheless if it has difficulty in getting cash in, then it may not afford to be able to declare a dividend.  (DR.R.SRINIVASAN, 2009)

Factors influencing dividend payments

The following additional considerations impact the payment of dividends:-

Investment opportunities

Where profitable investment opportunities exist there is a general tendency for such firms to have a low payout of dividends. Those firms that are considered to be a growth cycle tend to pay lower dividends but they represent better long term investment. Those firms that have reached maximum maturity or are in the process of a decline pay higher dividends because they are more in need of retaining the core investors.

Financial access

“A company which has easy access to external sources of finance can afford to be more liberal in its dividend pay-out. The dividend policy of such firms is relatively independent of its financing decisions” (DR.R.SRINIVASAN, 2009).  The converse also applies.

Costs of flotation

Those firms that are involved in the issue of securities in order to raise capital will incur flotation costs.  As such this element of external financing may well influence the Company decision on the dividend policy.

Corporate control

Additional share issues made by the firm may have an impact of diluting the shares already issued to other stakeholders. Companies vulnerable to hostile takeovers need to be particularly careful here.  The directors have to be careful as to how they deploy this strategy hence “The niggardly pay-out policy of the company may result in low market valuation of the company vis-à-vis its intrinsic value. Consequently the company becomes a more attractive target and is in the danger of being acquired.

Investor preference

The shareholders often have a strong influence on dividend policies where there are preference shareholders.  “A firm tends to have a high pay-out ratio if the shareholders have a strong preference towards current dividends. On the other hand, a firm resorts to retained earnings if the shareholders exhibit a clear tilt towards capital gains.”

Taxation

The amount of taxation that is to be levied on a Company will greatly influence its decision making policy relative to the payment of dividends.  Where the Government levies a high tax on the distribution of dividends this imposes a significant barrier towards the payment of high dividends.

Dividend stability

Most firms attempt to have a well-balanced and stable dividend policy; they try to avoid short term volatility in the payment of dividends but prefer to show a trend of a positive increase over time based upon the increased earning path and growth of the firm.

Advantages and disadvantages of paying dividends

“One way for companies to reward their investors is to pay dividends. Dividends are payments made by a company to its shareholders, with the total amount of the payment to each shareholder determined by the number of shares the investor owns” (Kennan, 2010)

Advantages

Disadvantages

The following table relates the disadvantages for paying out dividends:-

 Paying out dividends can impact the financial viability of the Company if this is accomplished at the detriment of something else. For example if there is insufficient cash flow to support the paying of dividends and the money is found by the taking out of loans which increases the liabilities of the firm. Equally, monies that are diverted to shareholders as dividends might happen at a time when the Company is in a critical growth pattern and as such this might deprive the Company from key growth objectives.  The lack of prudence in paying dividends and conducting due diligence on the financial profile of the Company can result in disastrous consequences for the Company – “examples of financial difficulties which are traceable to the payment of dividends which were not earned or which could not be met without reducing working capital below the limits of safety. The number of examples is practically infinite” (Stasosphere, 2009).  For example: “The failures of the Corn Products Co., The American Malting Company, the U. S. Realty Co. and the New England Cotton Yarns Co. were the direct results of unwarranted payments of dividends. The U. S. Leather Co., the National Cordage Co., the National Salt Co., the Consolidated Cotton Duck Co., and the International Cotton Mills Corporation, were all seriously weakened by-payment of dividends at the expense of their cash position.” (Stasosphere, 2009)

A regular frequency of dividend payments may result in unrealistic expectations of the shareholders It is the concept of relying on a stream of dividend income from their investment portfolio and the perception that this will be both on-going and increase over time. Such expectations are quick to manifest themselves in shareholder discontent if the expectations suddenly change

In addition the constant demands for dividends can impose a serious strain on the cash flow and prevent monies from being divested towards capital acquisitions and future growth of the company. “This can lead to an illiquidity spiral which hinders the company’s ability to pay dividends in the future.” (Visscher, 2009). Dividends are also not always the best way of rewarding the shareholders for investing in the Company For example those company members who are also drawing salaries receive similar dividends to those inactive shareholders. This makes dividend payments a less precise liquidity measure than other options at the option of the Company. Dividends are also often tax inefficient in terms of a reward offered by the Company. “At the corporate level, dividends are paid from retained, or after-tax, earnings. At the shareholder level, dividends are taxed as ordinary income rather than at the lower capital gains tax rates which would be available if stock appreciates in value and is sold. “(Visscher, 2009)

Elements of a dividend policy

It is important to examine the liquidity options in a Company before formulating a dividend policy for the business. This way you avoid the misfortune of developing a poor or unworkable dividend policy. This does not mean that you should stop or avoid paying dividends or that they become liquidity option of last resort. The key emphasis is that you need to go through a rationale decision making process before proceeding with dividend policy formulation and implementation.

A well thought through dividend policy will set and establish shareholder expectations. As such the shareholders will perceive when the Company will pay out dividends and the circumstances that make this practicable for the Company. Whilst this might on the face of it seem to be a compromise, nevertheless it is better that a purely ad hoc policy being in place. “Shareholders whose return-on-investment is annually subject to the board members’ generosity—or whims—are unlikely to be happy shareholders, especially if they depend on a consistent income stream.” (Visscher, 2009). Where there is no dividend policy in place the business might be subject to another problem that in particular plagues small businesses. The dividend might be determined by what the founder or shareholders think they need or want as opposed to what is suitable and in the best interests of the Company.  When framing the policy there are a number of important key questions to address:

1. Who in the company will determine the dividend policy?
2. When should dividends be paid out?
3. What circumstances should limit dividend payments?
4. How large should any dividend be – the cap?
5. How flexible should the dividend policy be?

Small business implications

The problem with many small –medium business operations is that they do not have a firm dividend policy. This in itself is an important omission and can lead to arguments amongst the key stakeholders of the firm. In addition, a dividend policy that has not taken into account the liquidity factors of the business, together with external capital requirements, capital needs, is a serious error.

Lack of liquidity:  This must be considered as one of the most common complaints thatare voiced by small business shareholders. As the business expands this is normally one of the first areas of the business where the shareholders get disgruntled i.e. we are making more money so why are we not getting paid higher and more frequent dividends for our return on investment?  This is shallow thinking and putting personal needs ahead of the long term viability and growth of the business.  Those shareholders that are managing the business tend to be more realistic and are keen to re-invest in the business on the strength of growth and planning for bigger returns later. “They prefer to see “excess” cash reinvested in the business, rather than frittered away on dividends. But the inactive shareholders tend to see their equity as an investment on which they are entitled to a return comparable with other investments.” (Visscher, 2009). This sort of difference in views can be the ruination of start-ups where they are simply thought of as being ‘cash cows’ as opposed to long term growth investments.

Maximizing value:  In order to maximize the value for the shareholders  the Board of Directors has to balance a number of conflicting demands. The requirements of the investors, the liquidity and cash flow of the Company, the ability to set aside funds for expansion and growth of the business. The Board often end up compromising and they see the payment of dividends as more of an appeasement to the shareholders in order for their continued support and investment in the business.

So the dividends are really a vehicle in order to reward shareholders and offer them a return on investment; despite the fact that it is not always liquid or a prudent return.

Works Cited

Dr.R.Srinivasan. (2009, 11 19). Factors influencing the dividend policy. Retrieved 11 16, 2010, from Article base: http://www.articlesbase.com/finance-articles/factors-influencing-the-dividend-policysome-thoughts-1353067.html

Kennan, M. (2010, 4 15). The Advantages of Paying Dividends. Retrieved 11 17, 2010, from e-how: http://www.ehow.com/list_6321564_advantages-paying-dividends.html

Stasosphere. (2009). Effects Of Lack Of Prudence In Paying Dividends. Retrieved 11 17, 2010, from Chestbooks: http://chestofbooks.com/finance/private/Business/Effects-Of-Lack-Of-Prudence-In-Paying-Dividends.html

Visscher, F. M. (2009). Dividend policy in perspective. Retrieved 11 17, 2010, from de Visscher & Co: http://www.devisscher.com/articles/article5.htm