Firm's dividend policy divides net earnings into retained earnings and dividends. Retained earning privide necessary funds to finance long term growth while dividends are paid in cash generally.
1.) Wealth Maximization decesion: Because of the market imperfections and uncertainity, shareholders give higher value to near dividends than future dividends and capital gains. Payment of dividends influeces the market price of the share. Higher dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between the two approaches. When the firm increases retained earnings, shareholders dividends decrease and market price is affected, Use of retained earning to finance profitable investment increase future earnings per share. On the other hand increase in dividend may cause the firm to forego investment opportunities for lack of funds and thereby decreases the future earnings per share. Thus, management should develop a dividend policy which devices net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximisation for shareholders. Such policy will be influenced by investment opportunities avalable to the firm and value of dividends as against capital gain to shareholders.
2.) Long term Financing Decision: When dividend decision is treated as a financing decesion, net earnings are viewed as a source of long term financing. When the firm does not have profitable investment opportunities, dividend will be paid. the form grows at a faster rate when it accepts highly profitable opportunities. External equity is raised to finance investments. But retained earning are preferable because they do not involve floatation costs. Payment of cash dividend reduces the amount of funds necessary to finance profitable investment opportunities thereby restricting it to find other avenues of finance. Thus earnings may be retained as part of long term financing decision while dividends paid are distribution of earnings that cannot be profitably re-invested.
1.) Wealth Maximization decesion: Because of the market imperfections and uncertainity, shareholders give higher value to near dividends than future dividends and capital gains. Payment of dividends influeces the market price of the share. Higher dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between the two approaches. When the firm increases retained earnings, shareholders dividends decrease and market price is affected, Use of retained earning to finance profitable investment increase future earnings per share. On the other hand increase in dividend may cause the firm to forego investment opportunities for lack of funds and thereby decreases the future earnings per share. Thus, management should develop a dividend policy which devices net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximisation for shareholders. Such policy will be influenced by investment opportunities avalable to the firm and value of dividends as against capital gain to shareholders.
2.) Long term Financing Decision: When dividend decision is treated as a financing decesion, net earnings are viewed as a source of long term financing. When the firm does not have profitable investment opportunities, dividend will be paid. the form grows at a faster rate when it accepts highly profitable opportunities. External equity is raised to finance investments. But retained earning are preferable because they do not involve floatation costs. Payment of cash dividend reduces the amount of funds necessary to finance profitable investment opportunities thereby restricting it to find other avenues of finance. Thus earnings may be retained as part of long term financing decision while dividends paid are distribution of earnings that cannot be profitably re-invested.
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