The view that dividends are irrelevant is not correct, once we modify the assumptions underlying this view to consider the realities of the world. In practice, every firm follows some kind
or dividend policy. The typical dividend policy of most firms is to retain between one-third to half of the net earnings and distribute the remaining amount to shareholders. Companies generally specify dividends in terms of a dividend rate. They also tend to increase dividend rate if their profits increase substantially.
The questions, which relate to the dividend policy of a firm, are:
1. What are the preferences of shareholders? Do they want dividend income or capital gains?
2. What are the financial needs of the company?
3. How much should be paid out as dividends? What are the constraints on paying dividends?
4. Should the company follow a stable dividend policy?
5. What should be the form of dividends?
It is not easy to answer these questions. A number of factors will have to be evaluated to analyze each of these questions to evolve a long-tern dividend policy for the firm. Broadly speaking, to develop a long-term dividend policy, the directors should aim at bringing a balance between the desires of shareholders and the needs of the company.
Financial Need of the Company
The financial needs of the company may be in conflict with the desires of shareholders. Managerial prudence requires giving more weightage to the financial needs, of the company. However, retained earnings should be used as a source of financing only when the company has profitable investment opportunities. If shareholders themselves have better investment opportunities, the earnings should be distributed to them so that they may be able to maximize their wealth.
Generally speaking, when the company has an internal rate or return greater than the return required by shareholders, it would be to the advantage of shareholders to reinvest earnings. When the company does not have highly profitable opportunities and earns a rate on investments, which is lower than the rate required by shareholders, it is not proper to retain earnings. It is sometimes argued that, even if the company has highly profitable investment opportunities, earnings should be distributed and funds should be raised externally to finance the investment But the companies in practice prefer to retain earnings because issuing new share capital is inconvenient as well as involves flotation costs. If the company raises debt, the financial obligations and risk will increase. As a matter of fact, directors should neither follow. a practice of paying 100 per cent dividends, nor a practice of retaining 100 per cent earnings. The company should have a minimum payout ratio. If the profitable investment opportunities do not exist, it can pay some “extra” dividend, but still retaining some earnings for the continued existence of the enterprise. Though shareholders are the owners of the company and directors should follow a policy desired by them, yet the directors cannot sacrifice the interests of other groups, such as debt-holders, employees, society and customers. Shareholders are the residual claimants to the earnings of the company. Directors must retain some earnings, whether or not profitable investment opportunities exist, to maintain the company as a sound and solvent enterprise. Only a sound company will be able to meet its debt commitments, give maximum facilities and good salaries to its employees, manufacture and supply better quality products for its customers and contribute towards the social overheads by way of taxes and donations.
Thus, depending on the needs to finance their investment opportunities, companies may follow different dividend policies. Mature companies that have few investment opportuni-ties may generally have high payout ratios. Shareholders of such companies would be more interested in dividends, as they obtain return on their investments, than the company. The share prices of such companies are very sensitive to dividend changes. The directors of these companies retain only a small portion of the earnings to meet emergent financial needs and to finance the occasional investment opportunities and distribute the rest. On the other hand, growth companies may have low payout ratios. They are continuously in need of funds to finance their fast growing fixed assets. The distribution of earnings will reduce the funds of the company.
Therefore, sometimes the growth companies retain most of its earnings and declare bonus shares to satisfy the dividend requirements of shareholders. These companies would slowly increase the amount of dividends as the profitable investment opportunities start falling.