Dividend Policy What Are the Practical Considerations Essay

  • Length: 13 pages
  • Sources: 20
  • Subject: Economics
  • Type: Essay
  • Paper: #42117524

Excerpt from Essay :

Dividend Policy

What are the practical considerations which are likely to influence a firm's dividend policy? Does a firm's dividend policy matter?

Inside a firm's dividend policy there are a number of different factors that will have an impact upon: the amount and if one will be paid to shareholders. The most notable include: the growth rate of the company, credit agreements, earnings stability, maintaining control over the float, uncertainty, the ability of the company to receive financing from outside sources, financial leverage, age / size and possible tax consequences.

The Growth Rate of the Company

As far as the growth rate of the company is concerned, this will influence a firm's dividend policy by: requiring that a larger portion of their funds are used to support new opportunities in the future. This is because many growing companies may be in industries that are so new that it is not financially prudent to: pay out any kind of dividends to shareholders. Instead, they will reinvest this money back into the company to support: continued innovation and the ability of the organization to keep up with changes in the economy. (Shim, 2009, pp. 339 -- 341)

A good example of this occurred with EMC Corporation. They are large mainframe computer manufacturer based out of Boston, Massachusetts. When it comes to the dividend, they have never paid one to the shareholders of the company. The reason why, is because every year when the Board of Directors reviews this issue. They determined that it would be prudent to reinvent the money back into the corporation. This is important, because it shows how the dividend policy of a firm is based upon: the industry that they are in and the overall amounts of growth. In the case of EMC, they are unwilling to pay a dividend because of: the tremendous amounts of growth that are being experienced. Therefore, directors and executives believe that it is in the best interest of the shareholder to: continue to reinvest these funds back into the business. As, this will provide them with: greater long-term benefits down the road. ("Investor Relations")

Credit Agreements

Credit agreements could have an impact upon a company's dividend policy. In this case, they will be affected by the restrictive covenants in: various bond and credit contacts. These are specific provisions that are written into the bond contract or credit agreement that limits a company's ability to pay dividends. This is because; creditors want specific guarantees that they will receive the money they are owed, before the owners of the corporation (the shareholders) receive any kind of benefits. As a result, this will have an impact upon an organizations ability to pay dividends, with this placing: restrictions on the amounts or it could prohibit them completely. (Shim, 2009, pp. 339 -- 341)

Earnings Stability

Earnings stability can have an impact upon the dividend policy of the company, as it based on actual profits that they are making. What happens is when any kind of dividend is declared, a payment is made to the shareholders. It will specify a particular date in the future, as to when this amount will be received. This can be provided in numerous forms to include: special, cash, property and financial asset dividends. A special cash dividend is when the company is paying an additional bonus to investors. This can take place in the form of: cash, company stock or the securities of a subsidiary that was spun off.

A cash dividend is when shareholders are paid hard currency (based on the number of shares that they own). The amount that is being received from the company is taxable as ordinary income for the shareholders.

Property dividends are when the assets of another company are awarded to the stockholders. This usually means that they will receive the common stock for: a spin off or some kind of subsidiary that was sold.

Financial asset dividends are: when warrants or options are awarded to investors. As the value of these securities will be based upon, exercising the right to own the stock at a particular price in the future. ("Dividend Definition," 2009)

These different elements are important, because they are showing how corporations will use numerous forms of dividends to: compensate investors. As a result, the actual earnings of the company will have an impact upon the amount of the dividend. As, cash or other tangible assets, must be paid from income that was received. This means that most corporations must be: posting, consecutive positive earnings growth to pay the shareholders. Therefore, those organizations that have seen a long period of continuous expansion are: more than likely to pay dividends. As this will have a direct impact upon how much cash they have on: their balance sheet and the overall amount that they want to pay to shareholders. (Shim, 2009, pp. 339 -- 341)

Maintaining Control of the Float

Maintaining control of the float is when management or the board of directors is: wanting to limit the amount of influence that outside shareholders could have on the company. This is because, many dividends will often involve investors receiving additional stock (such as: a stock split). This can be problematic, as it will give the Treasury less control of: the total amount of shares that are outstanding. As, this is exposing the company to: hostile takeovers or unannounced tender offers. (Shim, 2009, pp. 339 -- 341)

At the same, maintaining control of the float will help to increase earnings stability. In this case, various stock splits can have a negative impact on corporate profits by reducing them. This is because each split, will reduce the overall earnings per share of the company. This can make it more difficult to post higher profit margins. As this will eat away at any kind of earnings momentum they are experiencing. Therefore, the dividend policy will be influenced based upon this factor. As, it can reduce the authority of: the board of directors / management and have an effect on corporate earnings. (Shim, 2009, pp. 339 -- 341)

Outside Sources of Financing

The ability of a company to have access to outside sources of financing will have an effect upon the dividend policy. As, those organizations that have contact with: the capital markets, better credit ratings and favorable relationships with the banks will have a higher dividend payout. The reason why, is because these different alternative sources can be used as a way to find other forms of investment capital. This means that they can payout: a higher percentage of their earnings and cash out to shareholders in the form of dividends. A good example of this can be seen with Phillip Morris, as these factors are helping the company to payout higher dividends in comparison with other industries. In this case, the company is paying out 65% of their earnings in the form of a dividend to the shareholders. This is because they have the above factors working in their favor, which is allowing them to offer investors higher dividends. (Wenning, 2011)

However, for those corporations that is having challenges in: securing financing from outside sources. This can have an adverse impact upon their dividend policy going forward. The reason why is because, they are forced to use the funds that could go towards the dividend payout. As they are being utilized to: increase growth and expansion.

A good example of this can be seen with Citigroup during early 2009 when they suspended their dividend. What happened was: the financial crisis and subsequent recession meant that the company faced a number of different challenges in receiving access to: additional working capital. This forced the Board of Directors to suspend the dividend, in effort to increase the overall amounts of resources that they had available. As a result, this is highlighting how the underlying dividend policy of a company will depend upon their ability to: have access to outside sources of financing. Those organizations that have contact with a variety of different markets will: have a higher dividend payout and a more favorable dividend policy. (Gelsi, 2009)

Financial Leverage

Financial leverage is when the company's dividend will depend upon the overall amounts of debt that they have on their balance sheet. What happens is a variety of corporations will often use debt as way to finance growth. However, if the business is not making any positive earnings or they have too much debt, this can have an impact upon their ability to borrow. As they are forced to: pay higher amounts of interest to creditors. This is problematic, because it means that they cannot pay shareholders any significant dividends. As more of the earnings and investments capital of the company, is going to satisfy the interest on their outstanding debt. (Shim, 2009, pp. 339 -- 341)

The Age and Size of the Company

The age and size of the company will have an impact upon the dividend by: influencing if one is paid and the overall amounts. What…

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