Factors Affecting Dividend Policy

Some of the factors that affect dividend policy include:

1. Investment Opportunities

Other factors are held constant. A company with more profitable investment opportunities will tend to pay fewer dividends than a company with fewer opportunities because the latter has less use for internally generated cash flows. The speed with which a company needs to respond to new investment opportunities depends on its industry. For technology companies, change occurs rapidly, so having internally generated funds available to react to profitable opportunities afford them flexibility.

2. The Expected Volatility of Future Earnings

The more volatile earnings are, the greater the risk that gains in a future period may not cover a given dividend increase. Companies are more cautious with the size and frequency of dividend increases when earnings are volatile.

3. Financial Flexibility

Companies may omit or reduce dividends to achieve the financial flexibility associated with having substantial cash on hand. Companies in a financially flexible and strong position are strategically advantaged to exploit new investment opportunities with minimum delay. Financial flexibility is important when access to liquidity is critical and when the dividend payouts are large. When increasing financial flexibility is important, a company may decide to distribute money in share repurchases. 

4. Tax Considerations

Different countries have different tax rates for investments—some tax both capital gains and dividends while others tax dividends. Taxation is a crucial factor that affects investments by reducing the after-tax earnings.

Taxation Methods

EBT is taxed at the corporate level in a double taxation system and then taxed again as dividends after distributing earnings to shareholders. On the other hand, the dividend imputation tax system ensures that corporate profits distributed as dividends are taxed once, at the shareholder’s level. A split rate tax system taxes corporate earnings distributed to shareholders at a lower rate than retained earnings. The dividends are taxed at the normal rate at the shareholder’s level.

Shareholder preference for current income versus capital gains

Other factors are held constant; an investor will have a stronger choice for dividends if the tax rate on dividends is lower than capital gains. This is, however, not the case for institutions that are exempt from capital gains and dividend tax.

5. Floatation Costs

Flotation costs make it more expensive for companies to raise new equity capital than to use their own internally generated funds. In response to this, many companies avoid establishing dividends that would create the need to introduce new equity to finance projects.

6. Contractual and Legal restrictions

Contractual or legal restrictions often affect the distribution of dividends. In some countries, the payment of dividends is legally mandated. Bond indentures have contractual limits that require a company to maintain a specific ratio, e.g., current ratio and interest ratio, before paying out dividends. In a company with preference shareholders, ordinary shareholders are likely to be paid dividends after preference shareholders. 

Question

Which of the following is most likely a result of a company paying out more dividends?

1. Fewer investment opportunities.
2. High flotation cost on equity issuing.
3. Extreme contractual restrictions.

Solution

Correct Answer is A. A company with low prospects of future investment opportunities will payout more of its retained earnings.

B is incorrect.  High flotation costs discourage companies from establishing a level of dividend that would create the need to raise new equity.

C is incorrect. Bond indentures contain covenants that limit the dividends paid out to shareholders.

Reading 18: Analysis of dividends and Share Repurchases

LOS 18 (e) Explain factors that affect dividend policy in practice.