530 Making Key Strategic Decisions
The committee’s responsibility is to probe management’s rationales for its
policies and thereby assure itself that management has thought them through
and that the policies are within acceptable limits.
Dividend Declaration
One financial policy specifically for the board to decide is the declaration of
dividends. Dividends are paid only if the company declares them; this declara-
tion usually is made quarterly.
Some companies regularly distribute a large fraction of earnings, while
others retain a large fraction (or all) within the corporation. Although generous
dividends may suit shareholders in the short run, they can deprive the corpora-
tion of resources it needs to grow and thereby penalize shareholders in the long
run. Conversely, if a large fraction of earnings is retained, shareholders may be
deprived of the opportunity to make profitable alternative investments of
their own. Thus, the finance committee must balance the interests of the cor-
poration with the interests of individual shareholders.
Some boards take a simplistic approach to dividends: “Always pay out X%
of earnings,” or “Increase dividends each year, no matter what.” Both state-
ments are acceptable guidelines, but neither is more than a guide. In some
industries, a certain payout ratio is regarded as normal, and a company that de-
parts substantially from industry practice may lose favor with investors. Good
evidence suggests that a record of increasing dividends over time, or at least a
record of stable dividends, is well regarded by investors. By contrast, an erratic
dividend pattern is generally undesirable; it creates uncertainty for investors.
Dividend policy warrants careful analysis. The principal factors that the
board considers are:
- What are the company’s financial needs? These needs depend on how fast
the company wants to grow and how capable it is of growing. Or, as is the
case with some companies, what is needed to preserve the company dur-
ing a period of adversity? - How does the company want to finance its requirements for funds? It can
meet its needs by retaining earnings, issuing debt, issuing equity, or some
combination of these. Each source of funds has its own cost and its own
degree of risk. - What return does the company expect to earn on shareholder equity, and
what degree of risk is it willing to assume in order to achieve this objec-
tive? The trade-off between risk and return will determine the appropri-
ate type of financing and thus inf luence the extent to which earnings
should be retained or paid out in dividends.
These are complex questions. Moreover, the factors involved in arriving
at answers to them interact with one another. Consider the example of Cisco
Systems: