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What are the factors affecting the Dividend Policy of a firm?
A company’s dividend policy is influenced by its investment opportunities and the need for funds for its future projects. Generally, companies use retained earnings to source newer projects and expansion if they are in the growth phase. So, when it comes to paying dividends, growth companies often prefer to offer capital gains instead of current dividends.
Internal Financing Vs External Financing
Companies want to have the maximum financial flexibility in meeting their long-term project funding needs. To have such a situation, companies often rely on internal financing or retained earnings. It is easy to use internal financing to get the flexibility and ease a company seeks to have in its projects.
External financing is a binding contract in nature where companies must pay interests regularly. If a company sources funds from the market, it must release new shares. This requires floatation as well as agency costs. Therefore, when the companies need maximum reliability, they prefer retained earnings rather than external financing to fund their projects.
Some analysts argue that when the need for funding arises, companies should always go for external financing and pay the shareholders regular dividends. The shareholders are the real owners of the business and paying them is of utmost concern for the business. Therefore, when financing and funding a project is required, companies should go for external financing after paying all dividends to shareholders.
Shareholders of mature companies usually demand more dividends than growth companies. Mature companies have limited options of funding new projects, so they can offer more dividends to their shareholders when they are profitable. Growth companies usually have many opportunities and they need funds more than mature companies.
It is easy to see how the investment policies and funding needs of a company influence its dividend decisions.
Companies in their growth phase restraint themselves from paying hefty dividends, while mature companies distribute a significant portion of their profits as dividends among their shareholders.
By paying the dividends, a growth company cannot hope for operational flexibility. So, the growth companies are often deterred from paying dividends.
However, mature companies always pay increasing dividends in regular intervals to satisfy the needs of more income of their shareholders.
It is up to the board of directors of a mature company to decide how to form a dividend policy so that it can pay out the dividend to its shareholders. However, for a growth company, retaining the earnings for further investment in new projects is a better option.
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