Nature of the Factors Which Influence the Dividend Policy of a Firm

Nature of the factors which influence the dividend policy of a firm.

Growth and Profitability: The amount of growth a firm can sustain and its profitability is

related to its dividend decisions, so long as the firm (because of managerially imposed to external market constraints) cannot issue additional equity. Liquidity: The liquidity position of a firm is often an important consideration in dividend

decisions. Since dividends represent a cash outflow, it follows that the better the cash position and overall overall liquidity of the firm, the greater is the firm’s ability to pay (and maintain) a cash dividend. A growing, profitable firm may not be liquid, since it needs funds for new capital expenditures and to build up its permanent working capital position.

Cost and Availability of Alternative Forms of financing: The ability of a firm to raise money

externally will have a direct bearing on the level of dividends paid to shareholders. Clearly, a company that has easy access to the capital markets, and that can conveniently and economically raise funds in a number of alternative ways, will have greater latitude in setting dividend policy than a firm that has to rely heavily heavil y on earnings retention as a source of financing.

Managerial Control: Those in control might prefer to minimize the likelihood of an offering of

equity to avoid any dilution in their ownership position. Hence, they would prefer a low payout  policy. On the other hand, a firm may establish a relatively high dividend payout ratio (if it  believes that is what shareholders desire) as a way to keep the firm from being acquired in a merger or acquisition.

Legal constraints: The legal rules act as boundaries within which a company can declare

dividends. In general, cash dividends must be paid from current earnings or from previous earnings that have been retained by the corporations after providing for depreciation. However, a company may be permitted to pay dividend in any financial year out of the profits of the company without providing for depreciation.

Access to the Capital Market: Another matter for consideration by management in setting an

appropriate dividend policy is the company’s ability to obtain cash on relatively short notice. This may be achieved by the company negotiating for a bank overdraft limit or having access to other short-term sources of funds.

Inflation: Inflation must be taken into account when a firm establishes its dividend policy. On

the one hand, investors would like to receive larger cash dividends because of inflation.

External Restrictions: The protective covenants in a bond indenture or loan agreement often

include a restriction on the payment of cash dividends. This restriction is imposed to preserve the firm’s ability to service its debt.