Question 5 OR (a)

Determinants of dividend policy

4 marks

Time to write
About 8 minutes

From an older CBCS paper

Question

Question 5 OR (a) · 4 marks

Discuss the determinants of a company's dividend policy. 4

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Read from the question

  • DiscussEach point named and explained, not just listed.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Funds, cost of capital, capital structure, investment opportunities 2 marks 3 min
  3. 2 Stock price, industry trend, shareholders' expectations, legal constraints 2 marks 3 min
  4. Check: every ask answered, key terms underlined 1 min

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks.

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

A company's dividend policy is shaped by the following factors:

Picture itDeterminants of dividend policy

1With the new plant half-built outside the window, the board votes to keep the coins in the bag.

Investment opportunitiesA company with profitable investments in hand prefers to retain more of its earnings to finance them.

2The retired couple at the AGM would rather have the envelope today.

Expectations of shareholdersShareholders who invest for regular income prefer current dividends to future growth.

  1. Availability of funds: when the business needs funds, retained earnings are a good source, saving flotation costs and avoiding dilution of control.
  2. Cost of capital: if finance can be raised through cheaper debt, more dividend can be paid; if new equity would be needed, retaining earnings is better.
  3. Capital structure: the dividend decision must respect the optimum debt–equity ratio.
  4. Stock price: higher dividends generally raise, and lower dividends reduce, the market value of the shares.
  5. Investment opportunities: a company with profitable opportunities in hand retains more.
  6. Trend of the industry: in industries where investors expect regular income, firms must pay dividends to keep their investors.
  7. Expectations of shareholders: income-seeking investors prefer current dividends; growth-seeking investors prefer retention.
  8. Legal constraints: section 123 of the Companies Act, 2013 limits the sources from which a dividend may be declared; one of them is the profits of the year arrived at after providing for depreciation.

The dividend decision also turns on whether profits should be ploughed back to finance investment, how much to pay, when (interim or final) and in what form (cash or bonus shares), all of which bear on the firm's future growth.

Where the 4 marks sit

#ComponentMarks
1Funds, cost of capital, capital structure, investment opportunities2
2Stock price, industry trend, shareholders' expectations, legal constraints2
Total4
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