Factors that Affect Dividend Policy
A company’s dividend payout policy is the approach a company follows in determining the amount and timing of dividend payments to shareholders. There are at least six factors that affect dividend policy:
- Investment opportunities
- Expected volatility of future earnings
- Financial flexibility
- Tax considerations
- Flotation costs
- Contractual and legal restrictions
On this page, we discuss each of these factors that determine the dividend payout policy of a company in more detail.
First of all, the availability of positive net present value (NPV) investment opportunities and the speed with which the firm needs to react to the opportunities determines the amount of cash the firm must keep on hand. If a company typically faces many profitable investment opportunities and/or it has to react quickly to take advantage of the opportunities (i.e., it does not have enough time to raise external capital), then the dividend payout may be low.
Expected volatility of future earnings
Second, firms may tie their target payout ratio to long-run sustainable earnings and may be reluctant to increase dividends unless a reversal is not expected in the near future. Hence, when earnings are fairly volatile, firms are more cautious in changing the dividend policy.
Firms with excess cash and a desire to maintain financial flexibility may use stock repurchase programs instead of dividends as a way to pay excess cash to investors. Since stock repurchases plans are not considered sticky (i.e., there is no implicit expectation by the market of an ongoing repurchase program), then these plans don’t entail reduction in financial flexibility going forward.
Having cash on hand provides companies flexibility to meet unforeseen operating needs and investment opportunities, and is particularly important during times of crisis.
Investors are concerned about after-tax returns. Investment income is taxed by most countries; however, the ways that dividends are taxed tends to vary widely from country to country. The method and amount of tax applied to a dividend payment can have a significant impact on a firm’s dividend policy. Generally, in countries where capital gains are taxed at a more favorable rate than dividends, high-tax-bracket investors prefer low dividend payouts.
A lower tax rate for dividends compared to capital gains does not necessarily mean companies will raise their dividend payouts. Stockholders may not prefer a higher dividend pay-out, even if the tax rate on dividends is more favorable, for several reasons:
- taxes on dividends are paid when the dividend is received, while capital gains taxes are paid only when shares are sold
- the cost basis of shares may receive a step-up in valuation at the shareholder’s death. This means that taxes on capital gains may not have to be paid at all
- tax-exempt institutions, such as pension funds and endowments, will be indifferent between dividends or capital gains.
When a company issues new shares of common stock, a flotation cost of 3% to 7% is taken from the amount of capital raised to pay for investment bankers and other costs associated with issuing the new stock. Since retained earnings have no such fee, the cost of new equity capital is always higher than the cost of retained earnings.
Generally, the higher the flotation costs, the lower the dividend payout, given the need for equity capital in positive NPV projects.
Contractual and legal restrictions
Companies may be restricted from paying dividends either by legal requirements or by implicit restrictions caused by cash needs of the business. Common legal and contractual restrictions on dividend payments include:
- the impairment of capital rule: a legal requirement in some countries mandates that dividends paid cannot be in excess of retained earnings
- debt covenants: these are designed to protect bondholders and dictate things a company must or most not do. Many covenants require a firm to meet or exceed a certain target for liquidity ratios (e.g., current ratio) and coverage ratios (e.g., interest coverage ratio) before they can pay dividends
We briefly discussed 6 factors that can materially affect the dividend policy of a company.