As discussed in the previous chapter, a firm’s dividend policy has the effect of dividing its net earnings into two parts:
retained earnings and dividends. The retained earnings provide funds to finance the firm’s long-term growth. It is one of the most significant sources of financing a firm’s investments. Dividends are generally paid in cash. Thus, the distribution of earnings uses the available cash of the firm. A firm which intends to pay dividends and also needs funds to finance its investment opportunities will have to use external sources of financing, such as the issue of debt or new common shares. Dividend policy of the firm, thus, has its effect on both the long-term financing and the wealth of shareholders. As a result, the firm’s decision to pay dividends may be shaped by the following two possible viewpoints.
Is it a Long Term Financing Decision?
When dividend decision is treated as a financing decision, the net earnings of the firm may be considered as a source of longterm funds. With this approach, dividends will be paid only when the firm does not have profitable investment opportunities. The firm grows at a faster rate when it accepts highly profitable investment projects. External equity could be raised to finance investments. But the retained earnings are preferable because, unlike external equity, they do not involve any floatation costs. The distribution of cash dividends causes a reduction in internal funds available to finance profitable investment opportunities and thus, either constrains growth or requires the firm to find other costly sources of financing. Thus, earnings may remain undistributed as part of a long-term financing decision. The dividends paid to shareholders represent a distribution of earnings that cannot be profitably reinvested by the firm. With this approach, dividend decision is viewed merely as a residual decision.
Is It a Wealth Maximization Decision?
One may argue that capital markets are not perfect; therefore, shareholders are not indifferent between dividends and retained earnings. Because of the market imperfections and uncertainty, shareholders may give a higher value to the near dividends than the future dividends and capital gains. Thus, the payment of dividends may significantly affect the market price of the share. Higher dividends increase the value of the shares and low dividends reduce the value. In order to maximize wealth under uncertainty, the firm must pay enough dividends to satisfy investors.
The management of a firm, while evolving a dividend policy, must strike a proper balance between the above-mentioned two approaches. When the firm increases the retained portion of the net earnings, shareholders’ dividends decrease and consequently the market price may be adversely affected. But the use of retained earnings to finance profitable investments will increase the future earnings per share. On the other hand, when dividends are increased, though there may be a favourable reaction in the stock markets, but the firm may have to forego some investment opportunities for want of funds and consequently, the future earnings per share may decrease. Therefore, management should develop such a dividend policy, which divides the net earnings into dividends and retained earnings in an optimum way to achieve the objective of maximizing the wealth of share-holders. The development of such policy will be greatly influenced by investment opportunities available to the firm and the value of dividends as against capital gains to the shareholders. The other possible aspects of the dividend policy relate to the stability of dividends, the constraints on paying dividends and the forms of dividends.