Dividend Policy What Are the Practical Considerations

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 happens is the older, more established companies will have more consistent and stable earnings. This has an impact upon their ability to: obtain financing and their image in the minds of the general public. These different factors are important, because they more than likely mean that these kinds of companies will be paying higher amounts of dividends to shareholders. While those organizations that are new and considered to be small, do not have access to the same forms of investment capital. This means that any kind of positive earnings that they are receiving must be: reinvested back into the company or used to cover various expenses. As a result, the age and size of a corporation will determine their ability to continue to: fund various operations and expansion. When these different conditions exist, it means that the company is older and larger. This is having a positive impact upon their dividend, as they can offer shareholders additional financial incentives. (Shim, 2009, pp. 339 -- 341)

Possible Tax Consequences

Possible tax consequences will have an impact on the retained earnings of a corporation. In this particular situation, most companies will pay income tax on the earnings that were received. When a company begins to start paying dividends to shareholders, this means that they will have to pay tax on the income that they are making. This can be problematic, because some of the more wealthy shareholders could be opposed to receiving such a large dividend. Since they control such a sizeable portion of the stock, means that the opinions of these individuals will be taken into account. This will have an impact upon: if a dividend is paid out and the overall amounts. ("What is the Double Taxation of Dividends," 2011) (Shim, 2009, pp. 339 -- 341)

A good example of this can be seen with Warren Buffet of Berkshire Hathaway. In every company that he purchases, he does not like the fact that they pay out dividends to their shareholders. The reason why, is because it increases his overall tax liability by: having to pay higher marginal rates from the dividends that were received. As a result, the views of Warren Buffet will have an impact upon these kinds of decisions that are made by the board of directors. Where, they want to ensure that he is satisfied with: the direction of the company and the potential long-term profits. Once this takes place, it increases an organization's ability to receive additional investment capital and notoriety from having these kinds of investors in their company. (Buffet, 1999)

When you step back and analyze these different factors, it is clear that the combination of them together, will have an impact upon the overall amount of dividends that are being paid. As they will often work, in an interconnected fashion to: influence the decisions of the board of directors. Where, they will look at all of these different elements combined to decide: if a dividend should be paid and the overall amount. This is significant; because it shows how there are a variety of factors that will influence these views among: a variety of corporations.

Does a firm's dividend policy matter?

Yes. The reason why this matters is because the dividend, will determine why the stock is selected for a particular investment. For example, a company that has a consistent track record of paying dividends over a long period of time will be attractive to: investors who are seeking out income or growth / income. The reason why, is because they have a consistent history of: paying dividends over long periods of time. As, investors will look at: the dividend amount and the track record of the company going back as far as 20 years. Those companies that meet this criterion will receive more favorable views from these kinds of investors. (Graham, 1976)

A good example of this can be seen by looking at the dividend that has been paid by Pfizer. If you look at the track record of the company going back to 1982, they have a consistent history of paying and raising their dividends during this time. This provides a form of clarity to many investors, as the products that they are selling are considered to be defensive (which reduces their overall amounts of volatility). While, the consistency of the dividend will make the stock more: marketable to conservative shareholders (as this can provide them with an above average return in comparison with other investments). This is important, because it shows how the dividend policy of the company, will determine how marketable they are to: conservative investors and institutions. ("Pfizer," 2011)

At the same time, many individuals will look at the dividend, to determine the overall amounts of long-term capital appreciation. In this particular situation, they will examine the information on a company's dividends to: decide if it meets their investment criteria. Those companies that are not paying: large amounts of dividends or no dividend; will be viewed as a possible investment that can help them achieve their different objectives. (Graham, 1976)

A good example of this can be seen with Amazon.com. In this situation, investors are not concerned about the fact that the company is paying a dividend. Instead, they are interested in the overall amount of capital appreciation that they can see. As the company has the ability to provide above average growth, which will have an impact upon what kind of investors will want to purchase the stock. This is important, because it shows how the dividend policy will determine the type of investors, who are seeking out the company and the overall return that they are looking for. ("Amazon.com," 2011)

When you step back and analyze these different factors, it is clear that the combination of them together, will have an impact upon: the kind of investors that will purchase the stock and the return that they are seeking. As those companies that pay more consistent amount of dividends, will affect what kinds of: conservative investors and institutions will be interested in their corporation. While, those companies that are not paying any dividends will seek out: speculators and aggressive investors who want above average growth. As a result, the dividend policy of a company will decide what kind of shareholders will: own the stock and their investment time horizons. (Graham, 1976)

What are the main practical considerations which are likely to influence a firm's capital structure?

Simply put, the capital structure of firm is the permanent long-term financing structure of the company. This includes a number of different elements such as: the long-term debt, common stock, preferred stock, earnings, short-term debt and accounts payable. ("Capital Structure," 2011) As far as the capital structure is concerned, there are a variety of factors that will influence this. The most notable include: the growth / stability of sales, cash flow, the cost of capital, control, marketability, the size, floatation costs, growth opportunities and the level of economic development. ("Major Factors Affecting Capital Structure," 2008)

The Growth and Stability of Sales

The growth rate of the company and the stability of sales will determine the capital structure based upon: the financial soundness of the business model. What is happening, most creditors will look at: the balance sheet and the structure of the company (to decide the underlying strengths or weaknesses of the organization). This will affect the capital structure, as the strength of: business and the industry will have an impact on their ability to obtain some kind of financing. This is important, because this consideration will determine what kind of corporation will be established. ("Major Factors Affecting Capital Structure," 2008)

Cash Flow

The cash flow will affect the structure of the company, as it will determine an organization's ability to pay their long-term debts. In this situation, creditors want to know how much free cash flow they are generating. This is the total amount of profits that are being made by the company after all of: the expanses, interest and taxes have been paid. Those organizations that have consistent positive cash flow levels will have access to: greater amounts of capital in the public markets. This will determine what kind of company is: established and the kinds of securities / bonds that they are selling. ("Major Factors Affecting Capital Structure," 2008)

The Cost of Capital

The cost of capital will have an impact on the structure of company. The reason why is because, the ability to obtain access to financing, will determine the amounts of interest that they are paying. Those companies that have higher costs of capital; will have fewer options available to: them in the public markets. This could mean that they may decide to remain private or seek out some kind private placement / limited partnership. These are special investments that are given to sophisticated investors, who are willing to take larger risks and receive greater rewards. In this kind of situation, the inability to of having access to capital could mean that many businesses will seek out one of these alternate forms of financing. ("Major Factors Affecting Capital Structure," 2008)

Control

Control is when there is an emphasis on limiting the overall amounts of: stock, bonds and preferred stock that is available to the public. What is happening is the majority owners of a corporation, will often sell more stock or other securities to: increase their working capital. The problem is that if they sell too much of their control, various shareholders could have more influence over the decisions made by the board of directors. This can be problematic, as the loss of this kind of control, will mean that the company could go in another direction. As a result, this will impact the formation of business, as the majority owners will try to maintain a certain amount of influence at all times. ("Major Factors Affecting Capital Structure," 2008)

For example, treasury is stock are those shares that are purchased in: a stock buyback to limit the amount of outstanding shares available. This is important, because it means that the majority owners will use a number of different tools to: limit the overall amount of influence that various parties will have over the corporation. ("Treasury Stock," 2011) ("Major Factors Affecting Capital Structure," 2008)

Marketability

The marketability of the company is the amount of demand for their shares. As, those organizations that have higher levels of trading in their stock; will be seen as having: greater amounts of marketability. This is when shareholders have to purchase the stock, because it has the reputation of bringing them an above average return. The way that this affects the capital structure is: those organizations that have greater amounts of volume will see their prices move up and down. During times when the stock is steadily rising, this will affect the company's ability to attract new shareholders. As the price can rise to levels that will make it difficult for smaller investors to purchase the company. This will affect their capital structure, as the board of directors can declare a stock split. Once this occurs, it means the price will be reduced and the company will be more marketable to investors. This is important; because it shows how the marketability of the company will affect the way they will determine their capital structure. ("What is a Stock Split," 2011) ("Major Factors Affecting Capital Structure," 2008)