Page 209 - DCOM508_CORPORATE_TAX_PLANNING

Corporate Tax Planning

Notes 9.2.2 Dividend Policy

Dividend policies are the regulations and guidelines that companies develop and implement
as the means of arranging to make dividend payments to shareholders. Establishing a specifi c
dividend policy is to the advantage of both the company and the shareholder. In order to make
sure the policy is workable, a company should develop a viable policy and then run this policy
through a number of test scenarios in order to determine what impact the dividend policy would
have on the operation of the business.
A dividend policy shows how a company determines the amount of earnings to be paid out as
dividends to its shareholders on a regular basis. It is characterised by its dividend payout ratio,
which is the percentage of net earnings paid out to shareholders.

Did u know? The dividend payout ratio is the amount of dividends paid to stockholders
relative to the amount of total net income of a company. The amount that is not paid out in
dividends to stockholders is held by the company for growth. The amount that is kept by
the company is called retained earnings.

9.2.3 Determinants of Dividend Policy

Establishing a dividend policy is important for business that intends to provide stock issues
for investors. There are several determinants of dividend policy that are taken into account,
including the desire to remain within the parameters of current trade regulations, and to protect

the financial stability of the company. Considering all relevant factors and their impact on the
operation makes it easier to create a policy that is fair to the business and still attractive enough
to motivate investors to buy and hold the shares over the long term.

The main determinants of dividend policy of a firm can be classifi ed into:
1. Dividend payout ratio: Dividend payout ratio refers to the percentage share of the net
earnings distributed to the shareholders as dividends. Dividend policy involves the
decision to pay out earnings or to retain them for reinvestment in the firm. The retained

earnings constitute a source of finance. The optimum dividend policy should strike a

balance between current dividends and future growth which maximises the price of the

firm’s shares. The dividend payout ratio of a firm should be determined with reference to
two basic objectives – maximising the wealth of the firm’s owners and providing suffi cient

funds to finance growth. These objectives are interrelated.

2. Stability of dividends: Dividend stability refers to the payment of a certain minimum
amount of dividend regularly. The stability of dividends can take any of the following
three forms:
(a) Constant dividend per share
(b) Constant dividend payout ratio or

(c) Constant dividend per share plus extra dividend

3. Legal, contractual and internal constraints and restrictions: Legal stipulations do not
require a dividend declaration but they specify the conditions under which dividends
must be paid. Such conditions pertain to capital impairment, net profits and insolvency.

Important contractual restrictions may be accepted by the company regarding payment of
dividends when the company obtains external funds. These restrictions may cause the fi rm
to restrict the payment of cash dividends until a certain level of earnings has been achieved
or limit the amount of dividends paid to a certain amount or percentage of earnings.

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