Bank - Tips and Advice: Why dividend policies are NECESSARY
by aprilcheaw
FeedTheVillage.com - Tips and Advice: Why dividend policies are NECESSARY
Why does a company need a strategic policy relating to dividend payments? Because market participants current and potential stockholders generally do not like surprises. An erratic dividend policy means that those stockholders who like the last dividend cannot be sure that the next one will be to their liking. This uncertainly can result in a drop in the company's stock price. When stockholders do not get what they expect, they often show their displeasure by selling their stock. A well-planned policy, appropriate for the firm and its business strategy, can prevent unpleasant surprises for market participants and protect the stock price. Factors affecting dividend policy Dividend policy is based on the company's need for fund, the firm's cash position, its future financial prospects, stockholder expectations, and contractual restriction with which the firm may have to comply. 1- Need for fund Dividends paid to stockholders use funds that the firm could otherwise invest. Therefore, a company running short of cash or with ample capital investment opportunities may decide to pay little or no dividends. Alternatively, there may be an abundance of cash or a dearth of good capital budgeting projects available. This could lead to very large dividend payments. 2- Management expectations and dividend policy If a firm's managers perceive the future as relatively bright, on the one hand, they may begin paying large dividends in anticipation of being able to keep them up during the good times ahead. On the other hand, if managers believe that bad times are coming, they may decide to build up the firms cash reserves for safely instead of paying dividends. 3- Stockholders preferences Reinvesting earnings internally, instead of paying dividends, would lead to higher stock prices and a greater percentage of the total return coming from capital gains. Capital gains are profit earned when the price of a capital asset, such as common stock, increase. Common stockholders in high tax brackets may prefer to receive their return from the company in the form of capital gains instead of dividends. Some stockholders prefer capital gains because the federal income tax rate on capital gains is limited to 20 percent. Returns in the form of dividends may be taxed at a stated rate as high as 38.6 percent in 2002. The effective tax rate on dividends, due to the phasing out of some deductions and exemptions for high income taxpayers, may be even higher. If the stock is not sold, capital gains taxes can postponed indefinitely. If, however, the stockholders are mainly retired people looking for current income from their investment, then they may prefer a high dividend payment policy. The board of directors should consider such stockholder preference when establishing the firm's dividend policy. 4- Restrictions on dividend payments A firm may have dividend payment restrictions in its exiting bond indentures or loan agreements. For example, a company's loan contract with a bank may specify that the company's current ratio cannot drop below 2.0 during the life of the loan. Because payment of a cash dividend draws down the company's cash account, the current ratio may fall below the minimum level required. In such, a case, the size of a dividend may have to be cut or omitted. In addition, many states prohibit dividend payments if they would create negative retained earnings on the balance sheet. The restriction is a prohibition against the initial capital.
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