Dividend policy helps the company to decide payout which should be distributed among shareholders. This decision can be of great importance for the business because it directly affects shareholders. When the company makes a profit, the question arises if it should be retained or given to the shareholders. So, dividend policy helps the company decide if profit should be distributed and the extent of distribution.
Although there are some theories like dividend irrelevancy theory which states there is no effect of dividends on the company’s shareholders. On the other hand, dividend relevancy theory states that dividend does matter for the shareholders. Hence, this makes the dividend announcement one of the most important decisions for the company.
Dividend policy theories
There are three theories related to the dividend policy of the company. These theories include dividend relevancy, dividend irrelevancy, and low payout of the dividend.
Dividend relevancy theory
Dividend relevancy theory is of the view that dividends do matter for the shareholders. This theory states that shareholders depend on the dividend and expect companies to make regular payments for the dividend. In other words, shareholders are risk-averse and want to get a dollar today than two dollars tomorrow. This theory believes that a bird in the hand is better than two in the bushes.
Dividend irrelevancy theory
Dividend irrelevancy theory believes that dividends do not matter for the shareholders as they are seeking a return on investment with the price appreciation of the shares. Further, it has been observed that share price fall by the amount of dividend. So, there is no impact of the dividend on the wealth of the shareholders. For instance, if the company’s current share price is $12 and the company pays $2 as divided, the share price will fall to $10. Hence, payment of the dividend is irrelevant for the shareholders.
Further, valuation analysts do not just rely on the dividend but several matrices of the economic factors, quality measurements, operational and financial aspects, market share of the company, external environmental factors, and other company strengths.
In addition to this, payment of the dividend does hurt the financial conditions of the company. This activity deprives the company of financing and limits growth. So, they may compromise on the purchase of the capital assets and feasible investment opportunities.
Even some companies have to finance the payment of a dividend from the debt. This increases financial leverage and the inherent risk of the company. So, shareholders prefer not to receive the dividend but appreciation of the capital.
Let’s understand the example. Suppose a company fixes the dividend of $1 per share, and the company is committed to paying this amount of dividend to the shareholders irrespective of the fact that they earn a profit or no. So, it’s dividend irrelevance theory.
Types of dividend policy
There are four types of dividend policies. These policies include regular, stable, residual policy, and no dividend policy. Let’s understand these types of dividend policies.
Regular dividend policy
In a regular dividend policy, the company makes regular payments of the dividend. There is no effect on the dividend whether the company makes a profit or loss. The company has to make payment of the dividend to fulfil the expectations of the shareholders.
The companies usually adopt this type of policy with stable earnings or the companies on the mature life cycle stage. These companies can afford to pay the regular dividend due to established business. On the other hand, this policy may not be of equal importance for the companies in starting days of the business.
Stable dividend policy
The company ensures payment of a certain payout from earned profits. If the company’s profit fluctuates, there is a fluctuation in the dividend with the same proportion. For instance, suppose a company has a 5% payout, and the company’s profit is $100,000. The dividend for the year would be $5,000. While in the second year, the company makes a profit of $80,000, and the dividend would be $4,000 (80,000*0.05). The important thing to note is that the company does not fluctuate payout while dividends may change due to changes in the profit.
This type of dividend suits the investors that are not much sensitive to the dividend.
Residual dividend policy
In residual dividend policy, payment of the dividend is not a priority of the company. The company ensures the allocation of profits for capital expenditures, working capital, and other investment opportunities. So, what’s left after these payments are distributed among shareholders as dividend. If nothing is left after making these payments, no dividend is paid.
No dividend policy
In this type, the company does not pay a dividend to the shareholders. Instead, all the profits are reinvested in the operations. This reinvestment helps the company to grow and reach its maximum potential.
It’s suitable for companies that intend to earn profit with capital appreciation instead of dividends.
Importance of dividend policy
A dividend policy is important for both shareholders and the company.
- It helps shareholders decide if they should develop some expectation from the company to receive the dividend. So, they can plan their expenses and other matters.
- It provides shareholders to understand if they should buy some specific stock or no.
- It helps shareholders to plan their expenses from expected earnings.
For the company
- This helps the company to calculate the timing and amount of the dividend payment.
- It signals to the current investor about the frequency of the dividend and helps attract new investors.
- It helps to develop an environment of trust and confidence between shareholders and the company.
- That encourages shareholders to retain ownership of the shares for a long time.
- It results in managerial discipline. Hence, things remain in line.
- Reliable and regular dividend payments support the health stock price.