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Subject 4. Factors Affecting Dividend Policy PDF Download
Several factors affect a company's dividend policy.

Investor Opportunities

A company with many profitable investment opportunities will tend to pay out less dividends than a company with fewer opportunities.

The Expected Volatility of Future Earnings

The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings.

Financial Flexibility

Well established and large firms have better access to the capital market than the new companies and may borrow funds from the external sources if there arises any need. Such companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to build up good reserves by reducing the dividend payout ratio for meeting any obligation requiring heavy funds.

Tax Considerations

Governments use the taxation of dividends to address different goals: either to encourage or discourage the retention or distribution of corporate earnings; to redistribute income; or to address other political, social, and/or investment goals. Most developed markets tax shareholder investment income: some tax both capital gains and dividend income, some tax only one of them, and some (e.g., Hong Kong) levy no tax on either dividends or capital gains.

Taxation methods:

  • Double taxation.

    The U.S. is often described as an example of a double-taxation system. If a company decides to pay out dividends, the earnings are taxed twice by the government because of the transfer of the money from the company to the shareholders. The first taxation occurs at the company's year-end when it must pay taxes on its earnings. The second taxation occurs when the shareholders receive the dividends, which come from the company's after-tax earnings. The shareholders pay taxes first as owners of a company that brings in earnings and then again as individuals, who must pay income taxes on their own personal dividend earnings.

    Consider this: you work all week and get a paycheck from which tax is deducted. After arriving home, you give your children their weekly allowances, and then an IRS representative shows up at your front door to take a portion of the money you give to your kids. You would complain since you already paid taxes on the money you earned, but in the context of dividend payouts double taxation of earnings is legal.

    The double taxation also poses a dilemma to management when deciding whether to reinvest the company's earnings internally. Because the government takes two bites out of the money paid as dividends, it may seem more logical for the company to reinvest the money into projects that may instead give shareholders earnings in capital gains.

  • Split rate.

    Germany and Japan have a split rate system under which dividends are taxed at a lower rate than retained earnings. This offsets the higher taxation of dividends at the individual level compared with taxation of capital gains. Shareholders in low tax brackets would prefer a higher payout since distributed income is taxed less. On the other hand, those shareholders in higher brackets would prefer a lower payout since capital gains receive a preferential tax treatment.

  • Imputation tax system.

    The UK, new Zealand and Australia have an imputation tax system under which personal income is "grossed up" by the amount of corporate tax paid but a credit is then allowed for corporate tax from gross personal tax due. As with the split-rate system, shareholders in lower tax brackets would prefer higher payouts since they actually receive a tax credit for the difference between the corporate rate and their individual rate.

What do investors prefer, dividends or capital gains? The trade-off between taxes on dividends and taxes on capital gains is an important part of the equation. Even if dividends were to be taxed at a lower rate than capital gains, it's still not clear that shareholders would necessarily prefer higher dividends.

  • Capital gains taxes are not paid until the stock is sold, and thus have a lower effective tax rate due to time value effects.
  • If a stock is held by someone till death, no capital gains tax is due when the beneficiary receives the stock.
  • Tax-exempt institutions such as pension funds and endowment funds are indifferent as to whether their return comes in the form of current dividends or capital gains.

Flotation Costs

The fact that it costs us something to issue or "float" a new issue needs to be taken into account (e.g., a person has to pay Merrill Lynch to sell the issue on his or her behalf, plus lawyers and accountants).

For newly issued common stock: re = D1 / P0 (1 - F), where F is the percentage flotation cost incurred in selling the new stock so P0 (1 - F) is the net price per share received by the company. However, for existing retained earnings, accumulated from profits, there is no floatation cost.

Dollars raised by selling new stock must "work harder" than dollars raised by retained earnings (re, the cost of new equity capital, is always greater than rr, the cost of retained earnings). Therefore, instead of paying dividends, firms with good investment opportunities typically want to utilize retained earnings as much as possible.

Contractual and Legal Restrictions

  • Legal restrictions. Except in a liquidation, companies can't pay dividends out of initial contributed capital, - must be out of accumulated earnings.

  • Restrictions from debt covenants. Certain minimum figures are such for such constraints as interest coverage, current ratio, and net worth, before any dividend payments may be considered.

  • Informal restrictions. Some companies may continue to pay a regular scheduled dividend even when earnings are down and even less than their dividend payments.

  • Implicit restrictions. For example, a rapidly growing company may not want to issue a dividend because shareholders could interpret a dividend as a lack of investment opportunities for the company. Banks, on the other hand, typically have a dividend yield that exceeds that of the overall market.

User Contributed Comments 1

User Comment
peter7gor is split rate also an example of double taxation?
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Your review questions and global ranking system were so helpful.


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