Dividend Decision

The third major decision in financial management is the dividend decision — how much of the company’s profit (after tax) should be distributed to shareholders as dividend, and how much should be retained in the business.

Dividend is the portion of profit paid out to shareholders as current income. Retained earnings, on the other hand, are profits kept in the business for reinvestment. This reinvestment increases the firm’s future earning capacity. The amount of retained earnings also affects the financing decision: if more profit is retained, the firm needs less external funds. Therefore, the dividend decision must be taken keeping in view the overall objective of maximising shareholders’ wealth.

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Factors Affecting Dividend Decision

Several factors influence how much profit a company distributes as dividend and how much it retains. The important ones are:

1. Amount of Earnings Dividends are paid out of current and past earnings. So, the amount of profit earned is the primary determinant of the dividend decision.
2. Stability of Earnings A company with stable earnings can afford to pay higher dividends consistently. In contrast, a company with unstable earnings is likely to pay smaller dividends.
3. Stability of Dividends Most companies follow a policy of stabilising the dividend per share. They increase dividends only when they are confident that the rise in earnings is permanent — not just a temporary or small increase. If the change in earnings is small or temporary, the dividend per share is not altered.
4. Growth Opportunities Companies with good growth prospects retain more earnings to finance investment. Therefore, growth companies typically pay smaller dividends than non-growth companies.
5. Cash Flow Position Paying dividend requires cash outflow. A company may be earning profit but still be short on cash. Availability of sufficient cash is necessary for declaring a dividend.
6. Shareholders’ Preference Management must consider what shareholders want. Some shareholders depend on a regular income from their investments. If most shareholders desire a minimum dividend, the company is likely to declare it.
7. Taxation Policy The choice between paying dividend and retaining earnings is affected by the tax treatment of dividends versus capital gains. If tax on dividends is higher, companies prefer to pay less dividend. Under the current tax policy, dividends are tax-free in the hands of shareholders, but a dividend distribution tax is levied on companies. This makes shareholders prefer higher dividends.
8. Stock Market Reaction Investors generally view an increase in dividend as good news, and stock prices rise. A decrease in dividend is seen negatively and can lower share prices. So, the likely impact on share price is an important factor in the dividend decision.
9. Access to Capital Market …