Firm’s dividend policy divides net earnings into retained earnings and dividends. Retained earnings provide necessary funds to finance long term growth while dividends are paid in cash generally. Dividend policy of the firm is governed by:
(i) Long Term Financing Decision: When dividend decision is treated as a financing decision, net earnings are viewed as a source of long term financing. When the firm does not have profitable investment opportunities, dividend will be paid. The firm grows at a faster rate
when it accepts highly profitable opportunities. External equity is raised to finance investments. But retained earnings are preferable because they do not involve flotation costs. Payment of cash dividend reduces the amount of funds necessary to finance profitable investment opportunities thereby restricting it to find other avenues of finance. Thus earnings may be retained as part of long term financing decision while dividends paid are distribution of earnings that cannot be profitably re-invested.
(ii) Wealth Maximization Decision: Because of market imperfections and uncertainty, shareholders give higher value to near dividends than future dividends and capital gains.
Payment of dividends influences the market price of the share. Higher dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between the two approaches. When the firm increases retained earnings, Shareholders’ dividends decrease and consequently market price is affected.
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