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Financial Management - DIVIDEND POLICIES

Factors which influence dividend decisions - DIVIDEND POLICIES

   Posted On :  20.06.2018 04:42 am

Normally all countries prohibit companies from paying out as cash dividends any portion of the firm’s legal capital, which is measured by the par value of equity shares (common stock) Other countries define legal capital to include not only the par value of the equity shares (common stock), but also premium paid if any (any-paid in – capital in excess of par).

Factors which influence dividend decisions

1. Legal constraints


Normally all countries prohibit companies from paying out as cash dividends any portion of the firm’s legal capital, which is measured by the par value of equity shares (common stock) Other countries define legal capital to include not only the par value of the equity shares (common stock), but also premium paid if any (any-paid in – capital in excess of par).

These capital impairment restrictions are generally established to provide a sufficient equity base to protect creditor’s claims.

We shall examine an example to clarify the differing definitions of capital:
 
Company XYZ Limited’s financial highlights as revealed from its latest balance sheet are as follows:

Equity share at par 1,00,000

Premium paid over par value (Paid-in capital in excess of par) 2,00,000
 
Retained earnings 1,40,000
 
Total shareholders equity 4,40,000
 
In states where the firm’s legal capital is defined as the par value of the equity share, the firm could pay out Rs 3,40,000 (2,00,000+1,40,000) in cash dividends with out impairing its capital. In other states where the firm’s legal capital includes premium paid if any (all paid-in capital), the firm could pay out only 1,40,000 in cash dividends.
 
An earnings requirement limiting the amount of dividends to the sum of the firm’s present and past earnings is sometimes imposed. In other words the firm cannot pay more in cash dividends than the sum of its most recent and past-retained earnings. However, the firm is not prohibited from paying more in dividends than its current earnings.
 
Thus dividends can be paid only out of the profits earned during a financial year after providing for depreciation and after transferring to reserves such percentage of profits as prescribed by law.
 
Due to inadequacy or absence of profits in any year, dividend may be paid out of the accumulated profits of the previous years.
 
Dividends cannot be declared for past years for which the accounts have been closed.
 

2. Contractual constraints

 
Often, the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan agreement. Generally, these constraints prohibit the payment of cash dividends until a certain level of earnings have been achieved, or they may limit dividends to a certain amount or a percentage of earnings. Constraints on dividends help to protect creditors from losses due to the firm’s insolvency. The violation of a contractual constraint is generally grounds for a demand of immediate payment by the funds supplier.
 

3. Internal constraints

 
The firm’s ability to pay cash dividends is generally constrained by the amount of excess cash available rather than the level of retained earnings against which to charge them. Although it is possible for a firm to borrow funds to pay dividends, lenders are generally reluctant to make such loans because they produce no tangible or operating benefits that will help the firm repay the loan. Although the firm may have high earnings, its ability to pay dividends may be constrained by a low level of liquid assets. (Cash and marketable securities)
 
We will take the previous example to explain this point. In our example, the firm can pay Rs.1,40,000 in dividends. Suppose that the firm has total liquid assets of Rs.50,000 (Rs.20,000 cash +marketable securities worth Rs.30,000) and Rs.35,000 of this is needed for operations, the maximum cash dividend the firm can pay is 15,000 (Rs.50,000 – Rs.35,000)
 
 

4. Growth prospects

 
The firm’s financial requirements are directly related to the anticipated degree of asset expansion. If the firm is in a growth stage, it may need all its funds to finance capital expenditures. Firms exhibiting little or no growth may never need replace or renew assets. A growth firm is likely to have to depend heavily on internal financing through retained earnings instead of distributing current income as dividends
 

5. Owner considerations

 
In establishing a dividend policy, the firm’s primary concern normally would be to maximise shareholder’s wealth. One such consideration is then tax status of a firm’s owners. Suppose that if a firm has a large percentage of wealthy shareholders who are in a high tax bracket, it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payments of taxes until they sell the stock.
 
Of course, when the equity share is sold, the proceeds are in excess of the original purchase price, the capital gain will be taxed, possible at a more favorable rate than the one applied to ordinary income. Lower-income shareholders, however who need dividend income will prefer a higher payout of earnings.
 
As of now, the dividend income is not taxed in the hands of the share holders in India. Instead, for paying out such dividends to its share holders, the company bears the dividend distribution tax.

6. Market Considerations

 
The risk-return concept also applies to the firm’s dividend policy. A firm where the dividends fluctuate from period to period will be viewed as risky, and investors will require a high rate of return, which will increase the firm’s cost of capital. So, the firm’s dividend policy also depends on the market’s probable response to certain types of policies. Shareholders are believed to value a fixed or increasing level of dividends as opposed to a fluctuating pattern of dividends.
 
In other words, the market consideration is a kind of information content of the dividends. It’s a kind of signal for the firm to decide its final policy. A stable and continuous dividend is a positive signal that conveys to the owners that the firm is in good in health. On the other side, if the firm skips in paying dividend due to any reason, the shareholders are likely to interpret this as a negative signal.
 

7. Taxation

 
The firm’s earnings are taxable in many countries. This taxation is applied differently in different countries. One can group these different taxation practices as under:
 

Single Taxation

 
The firm’s earnings are taxed only once at the corporate level. Share holders whether they are individuals or other firms do not pay taxes on the dividend income. They are exempt from tax. However the shareholders both individuals and other firms are liable for capital gains tax. India currently follows this single taxation. Under this, the firms in India pay 35% tax on their earnings and they will have to pay additional tax at 12.5% on the after tax profits distributed as dividends to the shareholders. The experience shows that after the implementation of this single taxation, Indian firms have started sharing a sizeable portion of their earnings with their shareholders as dividends
 

Double taxation

 
Under this, the shareholders’ earnings are taxed two times: first the firms’ profit earnings are taxed as corporate tax and then the shareholders’ dividend earnings out of the after tax profits are taxed as dividend tax.

Split rate taxation

 
Under this, the firm’s profits are divided into retained earnings and dividends for the purpose of taxation. A higher tax rate is applied to retained earnings and a lower one to earnings distributed as dividends. As share holders pay tax on dividends and tax on capital gains, this lower tax rate can be justified. But for a lower tax rate on the dividend income, the system works on the same lines as that of double taxation.
 

Imputation taxation

 
The advantage of this system is that the shareholders are not subjected to double taxation. A firm pays corporate tax on its earnings. Shareholders pay personal taxes on their dividends but they will get full or partial tax credit for the tax paid by the firm on its original earnings. In countries like Australia, the shareholders will get full tax relief or tax credit while in Canada, only partial relief is provided.
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