Page 214 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 9: Dividend Decisions

9.3.2 Limitations of Stable Dividend Policy Notes

In spite of the above discussed advantages the stable dividend policy suffers from certain
limitations. They are:

(a) Difficult to Change: Once a stable dividend policy is established, it cannot be changed
without affecting investors' attitude and financial position of the company, in the minds
of investor.
(b) Adverse Effect on Market Price of Share: As we have discussed in the advantages, about the
investors desire for current income to meet their living expenses, the investors who prefer
or depend on stable dividends, may feel bad, when the firm cuts dividend, consequently
they may sell some of their shares to fulfill the gap between expected dividend and the
actual dividend received (negative dividend). This leads to the reduction in the share
price. Hence, directors have to maintain stability in dividends, in lean years.
(c) Long-Run Effect on Company: When a firm maintains stable dividend policy in lean years
over a period of time with borrowed funds it may lead to death in the long-run.

Self Assessment

Fill in the blanks:
1. Dividend refers to that portion of companies ……………… that are paid out to the equity
shareholders.
2. Distribution of profits between dividends and retained earnings affects the ………………
of the firm.
3. Dividend policy of a firm affects both ……………… and owners' wealth.
4. Investors' desire for current income is one of the advantages of ……………… policy.

9.4 Factors Influencing Dividend Policy

Maximization of owners' wealth is the objective of the financial manager's job. Whatever decision
he/she takes, whether it is investment decision, financing decision or dividend decision, he/she
has to maximize value of the firm. There is a positive relation between dividend policy of a firm
and value of the firm that is payment of dividend affects the value (increases) of the firm.
Dividend policy means, the formation of a policy by the company regarding the payment of
dividend from profits to ordinary shareholders year to year. It determines the ratio between
dividend and retained earnings. Then, what type of dividend policy do firms adopt? Whether it
is 20 per cent, or 40 per cent or 80 per cent or any other percentage of earnings available to
shareholders? The two important dimensions of dividend policy are, what should be the dividend
payout ratio? How stable should the dividends be over time?
The policy relating to dividend payout ratio and earnings retention varies not only from industry
to industry but also among companies within a given industry and within a company from time
to time. These variations are because of factors influencing/affecting dividend policy. But financial
executives have to make a balanced judgment between the financial needs of the company and
desires of the shareholders. In other words, financial executive have to determine optimum
dividend policy that should strike the balance between current dividends and future growth
which maximizes the price of the firm's shares.

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