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What are the objectives of a company's Dividend Policy?
Companies use their net earnings either to keep them as retained earnings or to distribute them as dividends. The need for retained earnings or dividend payout is solely a matter of management's decision. However, in the case of a conflict to choose between the two, it is up to the dividend policy of the firm that is created before earning a net income.
The objectives of a company's dividend policy can be divided into two major parts.
The Company's Need for Funding its Future Projects
Firms may use the net earnings as retained earnings to fund their future projects.
As retained earnings have some great advantages over debt and loans, the firms that earn enough net earnings can choose to invest the money in some more profitable projects rather than paying it as dividends.
Usually, when a company takes a loan or sources its funds from the market, it has to pay a significant amount of interest on the loans. This is a disturbing factor for companies that want to focus on growth without having to focus on the interest. Retained earnings help companies sail through the needs of funding by using the net income without having to pay dividends and loans.
The Shareholders Need for Income
When a company earns net income, its shareholders may ask for dividends as they need more income from the company’s earnings. It is easy to see why the shareholders ask for returns. The shareholders invest money in the hope of return and they resort to relying on dividends to increase their earnings from the shares they own.
The investors of a competitive firm invest in the company’s project in the hope of earning a good income as dividends. So, when the company earns profits, the shareholders may want to get precedence over retained earnings and in favor of dividends. It is therefore a matter of the previously set decisions to decide how and when to pay the shareholders when the company earns a net income.
Conclusion
It is observable that when a company earns a net income, there is a two-way pull from the needs of the company and the shareholders who want to grab the money generated by the business of the company. The company wants money for further funding of new or current projects and shareholders want dividends to increase their income.
In such a situation of tug-of-war, the company should have to rely on rules that have been set much before the projects start. If there are no stringent rules, it may lead to unsolvable agency problems that can derail the operational efficiency of a firm.
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