refers to the policy chalked out by companies regarding the amount it would pay to their shareholders as dividend. With profit making comes the question of utilizing the profit gainfully.
The companies have two options with them:
- They can retain these profits within the company
- They can pay these profits in the form of dividends to their shareholders
The dividend policy to be adopted by the company is based on these two options. Once this is sorted out, a permanent dividend policy can be put into place. These policies shape the attitude of the investors and the financial market in general towards the concerned company. The policies are decided according to the current and future financial positions of the company. The preference and orientation of the investors are also taken into account.
The following are the types of dividend policies:
- Constant Payout Ratio
- Constant Dollar Dividend Policy
- Regular with Extras
The dividend policy acts as a signal for investors for gauging the future earning possibilities as expected by the management of the company. The dividend policies are directed towards attracting investors to their company. This is termed as the clientele effect. The firms that hold back free cash flows are lesser in value than those firms, which allow free cash flows and pay dividends from them.
There are quite a few impediments to companies paying dividends to their shareholders.
Some of these constraints are as follows:
- Consideration of taxes
- Consideration of returns
- Contractual constraints
- Cash flow constraints
- Legal constraints
The dividend policy of a company has a relation with its common stock value. The Dividend Irrelevance Theory propounds that the dividend policy of a firm has no direct bearing on the cost of its capital or its value. The Dividend Relevance Theory, on the other hand, expostulates that the value of the firm is affected by its dividend policy. The Optimal Dividend Policy helps in increasing the value of the firm to the maximum.
A Dividend Reinvestment Plan (DRIP) provides the investor the opportunity to reinvest dividends obtained from the company back into the company. The firm can repurchase the existent shares or it may issue new shares.