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Factors Governing the Dividend Decision

Factors Governing the Dividend Decision

The dividend decision is one of the most important financing decisions of the company. A company should have either a policy on the distribution of profits (Reserve) among the investor or a policy on retaining the profits (reserve).

The potential investors of the company are more interested to know the implications of investing in the company.

The company should have to decide between making payments to shareholders and retaining the funds for the future.

The factors affecting the dividend decision are the following:

Profitability

The company’s profit is a key consideration for the Board when determining the dividend. The company’s profitability guides the Board. It is their duty to ensure that the company does not issue dividends on losses. A company can maintain a healthy capital structure despite high debt levels if its profitability is high.

Another factor is the operating profit margin. This percentage directs the Board of Directors. Companies may use the operating profit margin as a benchmark for calculating the annual dividend. The Board may decide to increase annual dividend payments if the profit margin is higher. However, if the margin falls below the historical average, the Board may decide to reduce the dividend.

Projected Earnings

The earnings forecast is key in calculating a company’s profits and dividends. The two most crucial aspects of earnings forecasts are how high the estimates are and how confident the forecasts are. It is more likely that a company will meet or exceed expectations if it has a history of accurately predicting its future earnings than if it has struggled to do so in the past.

On the other hand, the Board of Directors may decide to raise the dividend if the company’s prospects have improved recently, leading to a higher payout ratio and the possibility of an earnings surprise. As a result, potential buyers may choose to wait for further evidence of profitability before deciding whether or not to purchase the stock.

Stability of Earnings

Stable earnings of the company affect the dividend decision of the company. Suppose a company having stable earnings is in the position to declare more dividends during the period. If a company has low earnings during a period, it will not declare a dividend.

Cash flow position

The cash flow position of the company affects the dividend decision the company. More payments of the dividend to the investors result in outflows of cash. The company may have enough income, but on the other, it is equally possible that a company may not have sufficient cash to pay the dividend.

So in such a way, the cash flow position affects the dividend decision. If the company have a better cash flow position, the better will be the capacity of the business to pay out the dividend and vice-versa.

Shareholders preference

The shareholders’ preference also affects the dividend decision of the company. There are two kinds of shareholders-

(1) those shareholders who invest in the company to get regular income

(2) those shareholders who invest in the company to gain capital profits. If the majority of the shareholders are investing in the company to get regular income, then in such a case, the company should declare dividends according to their expectations.

On the other hand, if the majority of the latter types of shareholders, the company enjoys freedom in declaring the dividend.

Taxation policy

The company’s dividend decision depends on the government’s taxation policy. If the tax rate is higher on the dividend, the company should pay less and vice-versa.

But nowadays, dividend income is tax-free in the hands of shareholders. So shareholders like to get a higher dividend.