Explain the factors affecting the dividend decision.

Dividend decision of a company deals with what portion of the profits is to be distributed as dividends between the shareholders and what portion is to be kept as retained earnings. The following are the factors that affect the dividend decision.

(i) Amount of Earning: A firm pays dividend out of its current and the past earnings. This implies that earnings play a key role in the dividend decision. A company having higher earnings will be in a position to pay a higher amount of dividend to its shareholders. In contrast to this, a company having low or limited earnings would distribute low dividends.

(ii) Stable Earnings: When a company has a stable and a smooth earning, they are in a position to distribute higher dividend as compared to the companies who have an unstable earning. In other words, a company having consistent and stable earnings can distribute higher amount of dividends.

(iii) Stable Dividends: Companies generally follow the practice of stabilising their dividends. They try to avoid frequent fluctuations in dividend per share and opt for increasing (or decreasing) the value only when there is a consistent rise (or fall) in the earnings of the company.

(iv) Growth Prospects: Companies aiming for a higher growth level or expansion of operations retain a higher portion of the earnings with itself for re-investment. Thus, dividend of such a company is smaller as compared to the companies with lower growth opportunities.

(v) Cash Flow Position: Dividend payments require cash outflow. If a company is low on cash then the dividend will be lower as compared to the company which has more liquidity. Even if a company has higher profits, it will not be able to distribute high dividends if it does not have enough cash.

(vi) Preference of the Shareholders: A company must keep in mind the preferences of the shareholders while distributing the dividends. For instance, if the shareholders prefer at least a certain amount of dividend, then the company is likely to declare the same.

(vii) Taxation Policy: Taxation policy plays an important role in deciding the dividends. If the taxation policy is such that a high rate of tax is levied on dividend distribution, then the companies are likely to distribute lower dividends. On the other, it might prefer to distribute higher dividends if the tax rate is low.

(viii) Stock Market Reactions: The amount of dividend that a company distributes affects its stock market prices. An increase in dividend by a company is viewed as a good sign by the investors and the stock price of the company goes up. On the other hand, a fall in the dividends adversely affects the stock prices. Thus, while taking the dividend decision, a company must consider the probable stock market reactions.

(ix) Contractual Constraints: Sometimes, while giving out loans to a company, the lender may impose some restrictions in the form of agreement. These restrictions may be related to the dividend paid in the future. In such cases, the company has to keep such agreements in mind when distributing the dividends.

(x) Access to Capital Market: The companies that have a greater access to the capital market tend to pay higher dividends. This is because they can rely less on retained earnings and more on other sources due to the market access. The smaller companies who have lower access to capital markets tend to pay lower dividends.

(xi) Legal Constraints: Companies have to adhere to the rules and policies laid out by the Companies Act. Thus, any company needs to take care of such restrictions and policies before declaring the dividends.

Dividend decision relates to distribution of profit to the shareholders and its retention in the business for meeting the future investment requirements. How much of the profits earned by a company will be distributed as profit and how much will be retained in the business is affected by many factors. 

Some of the important factors are discussed below.

1. Earnings: Dividends are paid out of current and past year earnings. Therefore, earnings is a major determinant of the decision about dividend. 

2. Stability of earnings: Other things remaining the same, a company having stable earning is in a position to declare higher dividends. As against this, a company having unstable earnings is likely to pay a smaller dividend. 

3. Growth opportunities: Companies having good growth opportunities retain more money out of their earnings so as to finance the required investment. The dividend in growth companies, is, therefore, smaller than that in non-growth companies.

4. Cash flow position: Dividends involve an outflow of cash. A company may be profitable but short on cash. Availability of enough cash in the company is necessary for declaration of dividends by it. 

5. Shareholder Preference: If the shareholders in a general desire that at least a certain amount should be paid as a dividend, the companies are likely to declare the same. 

6. Taxation Policy: If tax on dividend is higher it would be better to pay less by way of dividends. As compared to this, higher dividends may be declared if tax rates are relatively lower. 

7. Stock Market reaction: For investors, an increase in dividend is good news and stock prices react positively to it. Similarly, a decrease in dividends may have a negative impact on the share prices in the stock market.

8. Access to Capital Market: Large and reputed companies generally have easy access to the capital market and therefore, depend less on retained earnings to finance their growth. These companies tend to pay higher dividends than the smaller companies which have relatively low access to the market. 

9. Legal constraints: Certain provisions of the Company’s Act place restrictions on payouts as a dividend. Such provisions have to be adhered to while declaring dividends. 

10 Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future The companies are required to ensure that the dividends do not violate the terms and conditions of the loan agreement in this regard.