Dividend Decisions^335
Also a high dividend policy may force the firm to go to the capital markets more often.
In practice, most firms try to follow a policy of paying a steadily increasing dividend.
This policy provides investors with stable, dependable income, and if the signalling
theory is correct, it also gives investors information about management's expectations
for earnings growth.
Most firms use the residual dividend model to set a long run target payout ratio which
permits the firm to satisfy its equity requirements with retained earnings.
Factors Affecting Dividend Policies
Fund Requirements: Generally, the firms that have substantial investment opportunities
and consequently considerable funding needs to keep their payout ratio rather low to
conserve resources for growth. On the other hand, firms which have rather limited
investment avenues usually pursue a more generous payout policy.
Bond indentures: Debt contracts often restrict dividend payments to earnings
generated after the loan was granted. Also, debt contracts frequently stipulate that no
dividends can be paid unless the current ratio, the interest coverage ratio, and other
safety ratios exceed stated minimum values.
Preference share restrictions: Typically, equity dividends cannot be paid if the
company has omitted (not paid) dividend on its preference shares. The preference
dividends arrears must be paid before equity dividends can be resumed.
Availability of cash: Cash dividends can only be paid with cash. Thus, a shortage of
cash in the bank can restrict dividend payments. However, unused borrowing capacity
can offset this factor.
Control: If the management is concerned about maintaining control, it may be reluctant
to sell new shares, hence it may retain more earnings than it otherwise would. This
factor is especially important for small, closely held firms.
Differences in the cost of External equity and Retained Earnings: Cost of external
equity is obviously more than the cost of retained earnings due to the floatation costs of
raising the former. Therefore, if the company has some expansion plans which involves
capital expenditure it is very likely that it would prefer a low dividend payout ratio.
Signalling: As we have noted earlier, managers can and do use dividends to signal the
firm's situation. For example, if management thinks that investors do not fully understand
how well the firm is doing, and how good its prospects are, it may increase the dividend
by more than that was anticipated in an effort to boost the stock price.