SIGNIFICANCE OF DIVIDEND POLICY
Dividend policy of the firm is governed by:
(i) Long Term Financing Decision
As we know that one of the financing option is ‘Equity’. Equity can be raised externally through issue of equity shares or can be generated internally through retained earnings. But retained earnings are preferable because they do not involve floatation costs.
But whether to retain or distribute the profits forms the basis of this decision. Since payment of cash dividend reduces the amount of funds necessary to finance profitable investment opportunities thereby restricting it to find other avenues of finance.
Under this purview, the decision is based on the following:
1. Whether the organization has opportunities in hand to invest the amount of profits, if retained?
2. Whether the return on such investment (ROI) will be higher than the expectations of shareholders
(ii) Wealth Maximization Decision
Under this head, we are facing the problem of amount of dividend to be distributed i.e. the Dividend Payout ratio (D/P) in relation to Market price of the shares (MPS).
1. Because of market imperfections and uncertainty, shareholders give higher value to near dividends than future dividends and capital gains. Payment of dividends influences the market price of the share. Higher dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between the two approaches.
2. When the firm increases retained earnings, shareholders’ dividends decrease and consequently market price is affected. Use of retained earnings to finance profitable investments increases future earnings per share.
On the other hand, increase in dividends may cause the firm to forego investment opportunities for lack of funds and thereby decrease the future earnings per share.
Thus, management should develop a dividend policy which divides net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximization for shareholders. Such policy will be influenced by investment opportunities available to the firm and value of dividends as against capital gains to shareholders.
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