Explain the factors affecting the dividend decision.

Question

Philoid · Accepted Answer

Dividend is that part of profit after tax which is divided among the shareholders. Dividend policy is concerned with determining the portion of firms earning into dividend and retained earnings, that is to decide the payout ratio and retention ratio.

The factors affecting dividend policy of a firm are stated below -

1) Legal requirements - For any company there is no legal compulsion to distribute dividend, however there are certain conditions regarding distribution of dividend -

a. A company can pay dividend only out of the profit during the year, in case of loss it cannot pay dividend.

b. If the total Assets of the firm are less than the total liabilities then it cannot pay dividend

c. The total profit after tax cannot be distributed as dividend rather a part of it shall be transferred to retained earnings before paying dividend

2) Liquidity position - The dividend payout is affected by the liquidity position of the firm because the dividends are to be paid in cash.

3) Repayment need - If the firm has to retain its profit for the purpose of the repayment of the debt then the payout ratio will be less.

4) Future investment - If firm is expecting any investment opportunities having higher rate of return then retention ratio will be more than the payout ratio.

5) Stability of earning - The firm having stable earnings are more likely to pay larger dividend than those having fluctuating earnings.

6) Desire of control - If the finance manager anticipates any investment need in future, then in order to concentrate the control it will retain more profit so that no further issue of equity shares is needed.

7) Access to capital market - The firms having easy access to capital market for arranging additional finance do not require more retained earnings so there payout ratio is high.

8) Tax liability - The dividend income is taxable for an individual under the head Income from Other Sources, so the stockholders in higher tax bracket prefer capital gain than cash dividend.