Question 4 (b)
Determinants of dividend policy
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 4 (b) · 7 marksWhat are the various determinants of a firm's dividend policy? 7
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
Read from the question
- What areThe meaning first, then the main points.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Funds, cost of capital and capital structure 2½ marks 4 min
- 2 Stock price, investment opportunities and industry trend 2 marks 3 min
- 3 Shareholders' expectations and legal constraints 1½ marks 3 min
- 4 Other aspects of the decision 1 mark 2 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks. End with step 4 in a line or two.
Try it first. About 14 minutes for 7 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:
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.
- Availability of funds: when the business needs funds, retained earnings are a good source, saving flotation costs and avoiding dilution of control.
- 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.
- Capital structure: the dividend decision must respect the optimum debt–equity ratio.
- Stock price: higher dividends generally raise, and lower dividends reduce, the market value of the shares.
- Investment opportunities: a company with profitable opportunities in hand retains more.
- Trend of the industry: in industries where investors expect regular income, firms must pay dividends to keep their investors.
- Expectations of shareholders: income-seeking investors prefer current dividends; growth-seeking investors prefer retention.
- 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 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Funds, cost of capital and capital structure | 2.5 |
| 2 | Stock price, investment opportunities and industry trend | 2 |
| 3 | Shareholders' expectations and legal constraints | 1.5 |
| 4 | Other aspects of the decision | 1 |
| Total | 7 |
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