What is Dividend policy in financial management? Types, importance, and factors of dividend policy.

Dividend policy in financial management

Dividend policy plays a critical role in financial management, as it directly impacts a company’s relationship with its owners and affects its general financial health and growth possibilities. It includes the strategic decision-making process regarding the distribution of gains to shareholders in the form of dividends or reinvesting them back into the business. This paper aims to study the key aspects of dividend policy in financial management, considering the factors that influence these choices and the implications they have on the company and its stakeholders.


Types of dividend policy

There are three basic types of dividend policy that are used by companies. They are.

A. Stable payouts.

B. Target payout ratio.

C. Regular and extra earnings.

A. Stable dividends: A company following this type of strategy keeps a constant dividend rate independent of the real earnings level, and the company tries to keep it even when, during the recession, the earnings go down below the real dividends paid, trying to signal to the investor that this is a short phase and Earnings will go back up when the economy revives.

Companies believe that buyers will place a price on the shares of a company that pays stable dividends and only grows its payout payment when it thinks that an increase can be maintained. A stable payment policy Regardless of fluctuating wages, it is also helpful because many organizations make choices based on the real payout by the companies. Signaling effect of This type has already been mentioned above. This is the most popular type of dividend policy followed by companies. World over.

B. Target Payout Ratio: Although there is a reason to think that stable payouts have a good effect on a company’s share price, many companies set benchmarks for their desired payout share (or range). They only stray from this goal to achieve relatively stable dividends or stable and occasionally growing ones.

Lintner’s part states that companies seek to maintain a goal dividend payout ratio over the long run, but only with a lag. For example, a company may decide that it will pay around 40 percent of its earnings as dividends and only raise it when this number falls to 30 percent of the earnings that the company is fairly sure of. This is especially relevant in the case of companies with stable earnings and earnings growth because they can only maintain a goal payout ratio in the long run.

C. Regular and extra dividends: Especially when a company earns above average earnings for any reason that is non-recurring in nature, it offers a bonus dividend over and above the normal dividend it pays. This extra income could be due to the divestment of a building or business activities, and the company has no possible usage of the same.

In line with the suggestion that buyers prefer to receive the money back from the company rather than the company utilizing that money in non-business activities, the companies generally return the money to the shareholders. This marking of extra dividends or one-time payouts is given to help the investors understand the fact that extra payouts are non-recurring in nature, and this is the only year this is being paid.

Factors Affecting Dividend Policy

1. Fund Requirements: Generally, the companies that have large investment chances and, consequently, considerable funding are needed to keep their dividend ratio rather low to preserve resources for growth. On the other hand, firms that have rather limited Investment opportunities usually follow a more generous payout policy.

2. Bond indentures: Debt contracts often limit reward payments to earnings generated after the loan was granted. Also, debt contracts frequently stipulate that no Dividends can be paid unless the current ratio, the debt payment ratio, and other Safety ratios exceed the stated minimum numbers.

3. Preference share restrictions: Typically, stock payments cannot be made if the company has omitted (not paid) payments on its preference shares. The preference Dividend arrears must be paid before stock payments can be restarted.

4. Availability of cash: Cash rewards can only be paid with cash. Thus, a lack of Cash in the bank can limit dividend payouts. However, empty loan capacity can counter this factor.

5. Control: If the management is worried about keeping control, it may be reluctant to sell new shares; hence, it may keep more earnings than it otherwise would. This factor is especially important for small, closely held companies.

6. Differences in the Cost of External Equity and Retained Earnings: The cost of External Equity is clearly higher than the cost of keeping earnings due to the floatation costs of raising the former. Therefore, if the company has some growth plans that involve capital spending, it is very possible that it would prefer a low dividend payout ratio.

7. Signaling: As we have noted earlier, managers can and do use rewards to signal the firm’s situation. For example, if management thinks that buyers do not fully understand, depending on how well the firm is doing and how good its chances are, it may increase the reward. More than that was expected in an effort to boost the stock price.

8. Shareholder Preference: When stock owners have greater interest in the current dividend vis-à-vis capital gains, the firm may be tempted to follow a flexible dividend policy. Payout policy. While the choice of equity owners has some impact on the dividend policy of the firm, the dividend policy may have a bigger effect on the kind of owners who are drawn to it. Each business is likely to draw itself a customer that finds its repayment scheme attractive.

Implications of dividend policy in financial management

The dividend policy a company adopts can have significant implications for both the company and its shareholders:

  • Shareholder Relations: Dividend payments can be a strong tool to attract and keep investors, creating a good relationship between the company and its owners.
  • Stock Price Volatility: Dividend statements, changes, or omissions can affect the company’s stock price and investor opinion.
  • Capital Structure: A company’s dividend strategy affects its capital structure and the allocation of funds between stock and debt financing.
  • Reinvestment Opportunities: Dividend policy influences a company’s ability to reinvest profits in new projects or deals to drive growth.

Market Perception: Dividend policy shows the company’s financial health, growth possibilities, and management’s trust in the business.

The value of a dividend strategy can change based on the company and its shareholders. However, there are some general benefits that can be associated with having a well-thought-out payout strategy.

The importance of dividend policy

Provides a steady amount of income for owners. Dividends can provide a steady stream of income for owners, which can be helpful for retirees or those who depend on their investments for income.

Attracts and keeps donors. Companies that pay dividends are often seen as more attractive to investors, which can lead to a higher stock price. This can make it easier for the business to raise cash in the future.

Signals to the market that the company is financially strong. Dividends can signal to the market that the business is financially strong and has a history of profitability. This can make the company more attractive to buyers.

Reduces the chance of a stock price crash. Companies that pay dividends are less likely to experience a stock price crash, as buyers are more likely to hold onto their shares if they are getting regular payments.

Of course, there are also some possible downsides to having a payout policy. For example, dividends can lower the company’s ability to invest in growth. Additionally, if the company’s revenue drops, it may not be able to afford to pay dividends, which could disappoint owners.

Dividend policy is a crucial part of financial management that can greatly impact a company’s financial health and shareholder value. The plan picked should match the company’s growth chances, revenue, cash flow, and shareholder expectations. Whether a business chooses a stable, residual, or constant payout ratio method, the final goal should be to strike a balance between paying owners with rewards and keeping earnings for future growth. Additionally, businesses must consider cash flow, debt obligations, and tax effects while designing their dividend policy. A well-defined and consistent dividend strategy can improve investor trust and contribute to the long-term success of the company.

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