Question

Chandra Ltd, is a manufacturer of Laptops. It made a profit of 1000 crores. The director have proposed a dividend of 38%. As a finance manager of the company, what factors would you consider while formulating a dividend policy of the company?

Answer 1

Following factors should be considered while formulating a dividend policy of the company.

Factor # 1. General State of Economy:

As a whole, it affects the decision of the management to a great extent whether the dividend should be retained or the same should be distributed amongst the shareholders.

Factor # 2. Capital Market Considerations:

This also affects the dividend policy to the extent to which the firm has access to the capital market In other words, if easy access to the capital market is possible whether due to financially strong or, big in size, the firm in that case, may adopt a liberal dividend policy.

In the opposite case, i.e., if easy access to capital market is not possible, it must have to adopt a low dividend pay-out ratio, i.e., they have to follow a conservative dividend policy. As such, they must have to rely more on their own funds, viz retained earnings.

Factor # 3. Legal, Contractual Constraints and Restrictions:

This is one of the most significant factors which are to be taken into account while considering dividend policy of a firm since it has to be evolved within the legal framework and restrictions. It is not legally binding on the part of the directors to declare dividends.

Dividend shall be declared or paid only out of current profit or past profits after charging depreciation although the Central Government has empowered to allow any company for paying dividends out of current profits for any financial year before charging depreciation.

Factor # 4. Tax Policy/Tax Consideration:

The tax policy which is followed be a Government also affects the dividend policy of a firm. Whether it is better to declare and pay dividend in cash or by the issue of bonus shares, depends to some extent on the tax policy. Because, cash dividends are not even so attractive to the investors who are in higher tax brackets.

Factor # 5. Inflation:

Inflation may also affect the dividend policy of a firm. With rising prices, funds which are generated by way of depreciation may fall short in order to replace obsolete equipment. The shortfall may be made from retained earnings (as a source of funds). This is very significant when the assets are to be replaced in the near future. As such, the dividend pay-out ratio tends to be low during the periods of inflation.

Factor # 6. Stability of Dividends:

It should be given due weight-age for this purpose although the same may differ from one firm to another. The dividend policy, of course, should have a degree of stability, i.e., earnings/profits may fluctuate from year to year but not the dividend since the equity shareholders prefer to value stable dividends than the fluctuating ones.

Factor # 7. Dividend Pay-Out (D/P) Ratio:

Dividend Pay-out (D/P) ratio (i.e., percentage share of the net earnings/profits distributed to the shareholders by way of dividends) also affects the dividend policy of a firm. It involves the decisions either to pay out the earnings or to retain the same for re-investment within the firm. Needless to mention that retained earnings also constitute a reliable source of funds.

Therefore, if dividend is paid, cash will be reduced to that extent. For maintaining assets level and financing investment opportunities, a firm should obtain necessary funds either from the issue of additional equity shares or from debt and consequently if the firm fails to raise funds from outside, its growth will be adversely affected.

Factor # 8. Owner’s Considerations:

The dividend policy is also to be affected by the owner’s consideration of:

(a) Their opportunities of investment; and

(b) The dilution of ownership.

(a) Owner’s opportunities of Investment:

If the rate of return which is earned by a firm is less than the return which have been earned by the investors from outside investment, a firm should not retain such funds, which in other words, will be detrimental to the interest of the members although it is difficult to ascertain the rate of alternative investment as well as alternative investment opportunities of its shareholders.

Of course, the firm may evaluate such external rate from the firms belonging to the same risk class.

And if is found that the said rate is comparatively high, it should opt for a high (D/P) ratio or vice-versa. Thus, while deciding dividend policy of a firm, external investment opportunities should also be carefully considered.