Question 4 OR (b)
Determinants of dividend policy; why a stable dividend policy
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 4 OR (b) · 7 marks- Briefly explain the factors that determine a firm's dividend policy. Why would a firm follow a stable 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
Read from the question
- WhyReasons, not a description: each reason explained in a line or two.
- BrieflyShort headed points, no long paragraphs.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Factors that determine dividend policy 4 marks 7 min
- 2 Why a firm follows a stable dividend policy 3 marks 5 min
- 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 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.
Factors that determine dividend policy
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.
Why follow a stable dividend policy?
Here a stable dividend policy means a regular dividend per share, kept steady and changed only when a change in earnings looks lasting; the ICAI study material calls this a constant dividend policy and uses "stable" for a constant payout ratio. Firms follow it because:
- Investors who depend on dividend income (individuals and institutions meeting living and operating expenses) prefer a dividend amount maintained in this way;
- many companies believe it maximises the market value of their shares;
- it improves the company's image and investors' confidence;
- it makes it easier to raise funds later, since a firm with a steady dividend record can approach the market successfully;
- it has information content: a steady dividend signals confidence in sustainable earnings, while a cut is read as bad news.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Factors that determine dividend policy | 4 |
| 2 | Why a firm follows a stable dividend policy | 3 |
| Total | 7 |
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