Determinants of dividend policy

A. Dividend Payout (D/P) Ratio

Dividend policy involves decision to payout earnings or to retain them for reinvestment. D/P ratio indicates the percentage earnings distributed to shareholders in cash, calculated dividing the cash dividend per share by its earnings per share. The D/P ratio of a firm should be determined with reference to two basic objectives-maximising the wealth of shareholders and providing sufficient funds to finance growth.

B. Stability of dividends
It refers to the payment of a certain minimum amount of dividend regularly. It can take any of the following three forms: constant dividend per share, constant/stable D/P ratio, and constant dividend per share plus extra dividend.

1. Constant dividend per share: it is a policy of paying a certain fixed amount per share as dividend. 2. Constant payout ratio: it is a policy to pay a constant percentage of net earnings as dividend to shareholders. 3. Stable rupee dividend plus extra dividend: under this policy, a firm usually pays a fixed dividend to the shareholders and in years of marked prosperity, additional or extra dividend is paid over and above the regular dividend.

C. Legal, Contractual, and Internal Constraints and Requirements 1. Legal requirements

The conditions under which dividend must not be paid are: Capital impairment rules: A firm cannot pay dividend out of its paid-up capital or any other means by which there is capital reduction. This rule is framed to protect the claims of creditors and preference shareholders. Any dividend that impair capital are illegal and directors are personally held liable for the amount of illegal dividend.
Contd

 Net profits: The net profit requirement is complimentary to the capital impairment rule. It restricts that the dividend is to be paid out of the firms current profits plus past accumulated retained earnings. The firm cannot pay cash dividend greater than the amount of current profits plus accumulated retained earnings. If there are past accumulated losses, firstly losses should be set off from current earnings before the payment of dividend. Insolvency: A firm is said to be insolvent in two situations- (a) when its liabilities exceeds the assets; (b) when a firm is unable to pay its bills or long-term debt. if the firm is insolvent in either sense, it is prohibited from paying dividends. This rule is framed to protect the interest of the creditors.

2. Contractual requirements
Firms may be prohibited from paying dividends in excess of a certain percentage, say, 12%. Dividends may be restricted by insisting upon a minimum of earnings to be retained.

3. Internal constraints
Liquid assets Growth prospects Financial requirements Availability of funds Earnings stability Control

D. Capital market consideration

Another factor which affect dividend policy is the extent to which the firm has access to the capital markets. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt low dividend payout ratios.