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Practical Considerations in Dividend Policy

Practical Considerations in Dividend Policy

A discussion on internal financing  ultimately turns to practical considerations which determine the dividend policy of a company. The formulation of dividend policy depends upon answers to the questions:

• whether there should be a stable pattern of dividends over the years or

• whether the company should treat each dividend decision completely independent.

The practical considerations in dividend policy of a company are briefly discussed below:

(a) Financial Needs of The Company: Retained earnings can be a source of finance for creating profitable investment opportunities. When internal rate of return of a company is greater than return required by shareholders, it would be advantageous for the shareholders to re-invest their earnings. Risk and financial obligations increase if a company raises debt through issue of new share capital where floatation costs are involved.

(b) Constraints on Paying Dividends

(i) Legal: Under Section 205(1) of the Companies Act 1956, dividend is to be paid out of current profits or past profits after depreciation. The Central Government can allow a company to pay dividend for any financial year out of profits of the company without providing for depreciation if it is in the public interest. Dividend is to be paid in cash but a company is allowed to capitalise profits or reserves (retained earnings) for issuing fully paid bonus shares.

(ii) Liquidity: Payment of dividends means outflow of cash. Ability to pay dividends depends on cash and liquidity position of the firm. A mature company does not have much investment opportunities, nor are funds tied up in permanent working capital and, therefore has a sound cash position. For a growth oriented company in spite of good profits, it will need funds for expanding activities and permanent working capital and therefore it is not in a position to declare dividends.

Practical Considerations in Dividend Policy

(iii) Access to the Capital Market: By paying large dividends, cash position is affected. If new shares have to be issued to raise funds for financing investment programmes and if the existing shareholders cannot buy additional shares, control is diluted. Payment of dividends may be withheld and earnings areutilised for financing firm’s investment opportunities.

(iv) Investment Opportunities: If investment opportunities are inadequate, it is better to pay dividends and raise external funds whenever necessary for such opportunities.

(c) Desire of Shareholders: The desire of shareholders (whether they prefer regular income by way of dividend or maximize their wealth by way of gaining on sale of the shares). In this connection it is to be noted that as per the current provisions of the Income Tax Act, 1961, tax on dividend is borne by the corporate as (Dividend Distribution Tax) and shareholders need not pay any tax on income received by way of dividend from domestic companies.

(d) Stability of Dividends: Regular payment of dividend annually even if the amount of dividend may fluctuate year to year may not be, related with earnings.

Practical Considerations in Dividend Policy


Practical Considerations in Dividend Policy

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