Question 4 OR (b)

Six determinants of a company's dividend policy

6 marks

Time to write
About 12 minutes
Topic
Dividend theories and dividend policy

Question

Question 4 OR (b) · 6 marks

Explain any six determinants of a company's dividend policy.

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

12 minfor 6 marks

Read from the question

  • any sixThe paper asks for any 6, and this is one of them. Only 6 are marked: a further earns nothing.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Six determinants explained, one mark each 6 marks 10 min
  3. Check: every ask answered, key terms underlined 1 min

Try it first. About 12 minutes for 6 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 decides how much of its profit is paid out and how much is retained. The decision affects both the firm's long-term financing and its shareholders' wealth, so the finance manager weighs several factors. Six of them are:

Picture itSix determinants of a company's 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. Investment opportunities. A company with profitable investments in hand prefers to retain more of its earnings to finance them.
  2. Availability of funds and cost of capital. Retained earnings save flotation costs and avoid diluting control, which a fresh equity issue would cause. If the investment can be financed with cheaper debt, more can be paid out; if it would need new equity, retaining earnings is better.
  3. Capital structure. The dividend decision should keep the debt-equity ratio near its optimum.
  4. Share price. Higher dividends generally raise the market value of the shares and low dividends lower it, so the effect on the share price is weighed.
  5. Expectations of shareholders and the trend of the industry. Shareholders who invest for regular income prefer current dividends to future growth, and in some industries investors expect regular dividends, so firms must pay them to keep investors.
  6. Legal constraints. Section 123 of the Companies Act, 2013 lays down when a dividend may be declared, for example out of the profits of the year arrived at after providing for depreciation.

Other factors include the firm's liquidity (a dividend is a cash outflow), the stability of its earnings and its desire for a stable dividend, and restrictions in loan agreements.

Where the 6 marks sit

#ComponentMarks
1Six determinants explained, one mark each6
Total6
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