Factors that Affect the Dividend Policy Decisions of a Company

Finance ManagementBanking & FinanceGrowth & Empowerment

It’s observed that there is often a conflict between a company's needs for funds and shareholders’ desire for current income. Companies have to maintain a fine balance while devising a dividend policy in order to please their investors as well as to meet their own funding requirements. There are certain constraints in devising a dividend policy for shareholders from the point of view of a company. Some of these constraints are highlighted below.

Legal Restrictions

Companies are legally bound to distribute dividends according to certain rules and regulations.

  • For example, a company is not bound to offer dividends in all cases of net income.

  • Companies can pay stock dividends in case cash dividend payment is troublesome.

  • The governments may allow companies to withhold dividends in public interests.

There are many other legal restrictions that the companies must follow in devising a dividend policy.

Liquidity

Liquidity or cash reservoirs are another important constraint that may stop or permit companies to pay dividends to their shareholders.

  • Mature companies are usually very liquid and they can offer large sums of dividends (cash dividends) to their shareholders.

  • In contrast, growth companies, although profitable, may not have enough cash in their reserves to pay dividends to their shareholders.

Financial Status and Borrowing Issues

A company with high financial leverage may not be able to distribute funds as dividends because it needs to increase its liquidity.

  • A highly leveraged company is dependent on external financing for which it has to pay interests. So, when there is a net income generated, the company may try to repay its obligation to the lenders.

  • The shareholders of highly leveraged companies may therefore tend to access capital gains rather than current dividends. The companies that pay back the borrowed funds are allowed to get more investment by the lenders, so paying back the borrowed funds is a priority of the highly leveraged companies.

Reputation and Access to Capital Markets

Even highly leveraged companies that are profitable and have a proven history of paying back the loans can pay a dividend if they have access to capital markets. These companies can borrow funds from the capital markets to satiate the desire of shareholders’ income by paying dividends if it has access to capital markets.

Loan Agreement Restrictions

The lenders may prohibit a company from paying dividends until some rules are followed or some requirements are met. For example, lenders may need the company to have a 2:1 liquidity ratio if it wants to pay dividends. Therefore, even if the firms are profitable and can pay dividends, it may not do so for loan agreements that are pre-set while the loan is accessed from the lenders.

Inflation

Inflation reduces the value of dividends and hence when inflation is high, companies may avoid paying dividends. Even if some companies do pay dividends, the amount should be higher than normal dividends to meet the erosion in the value of the dividends.

Control

Depending on the nature of a company, managers and shareholders may exert their control over the company to pay or withhold dividends.

  • When the general management controls the company and finds paying dividends troublesome, the dividends may not be paid.

  • On the other hand, when shareholders have control over a company, they may command a payout from the net earnings.

raja
Updated on 31-Mar-2022 08:07:26

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