Investment opportunities available to the firm have an influence on dividend policy as well as stockholder’s requirements for capital gains versus current yield.
Investment opportunities are important determinants of dividend policy. A firm that has desirable investment alternatives available and has the potential for above-normal growth will find it suitable to retain a portion of net income. This action allows the firm to utilise equity funds at a lower cost than by selling new common stock. In recent years, firms in the electronics, data processing, and fast food franchising industries have grown at an above-normal rate, and have followed a practice of maintaining a low dividend payout ratio.
A firm whose investment opportunities are limited does not have high financing requirements and may choose a high dividend payout ratio. Firms in the automobile, appliance, and chemical industries service mature, saturated markets. Their investment alternatives generally tend to be limited. Consequently, many of the firms in these industries maintain relatively high dividend payout ratios.
Taxes and demographic characteristics influence the investor’s preference between capital gains and current yield. Stockholders in higher tax brackets would prefer to postpone current income for capital gains later on, which would be taxed at a lower rate. Stockholders in lower tax brackets would have a greater preference for current income. Similarly, stockholders in lower age brackets, who are just beginning to form households, would prefer capital gains over current income. Stockholders in higher age brackets would prefer current income and stability in dividends over long-term capital gains. Obviously, a firm cannot meet all of these requirements simultaneously. To some extent, investors are attracted to a firm because of its existing dividend policy. However, stockholders have been known to make their wishes known to management.
Restrictions in Loan Agreements
Dividend policy is also affected by restrictive clauses in loan agreements. Lenders prefer to specify sufficient restrictions in loan agreements with the idea of safeguarding their financial position. Generally, these restrictions require that a firm cannot pay dividends from earnings retained in the past. A firm may find that this restriction limits its ability to pay dividends even if it has sufficient cash to continue its existing dividend policy. Similar types of restrictions are also frequently utilised in new preferred stock issues. These restrictions may prevent a company from paying dividends on common stock until dividends on preferred stock have been paid.
The typical firm generates cash flows on a continuous basis. A growing firm will be able to invest its profits and depreciation shielded funds quickly. Thus, despite profits, a firm may not be in a liquid enough position to justify paying anything other than nominal dividends. A firm that is growing and has to expand its assets base would like to maintain a low dividend payout ratio.
Big MNCs have shareholders who number in the crores. The dominant groups in these companies are in no danger of losing their control of the corporation when new common shares are issued. Dominant groups, wishing to retain their control, seek to do all equity financing internally. Therefore, where corporate control is an important consideration, the dividend payout ratio tends to be low.
Dividend policies are also affected by the legal requirements of the state in which the firm is incorporated. In general terms, state requirements call for dividends to be paid only when the firm’s balance sheet shows positive retained earnings. Normal dividends cannot exceed accumulated retained earnings. Firms that are undergoing bankruptcy proceedings are also legally prevented from paying dividends. Finally, financial institutions, such as insurance companies and pension funds, are limited to a certain list of firms in which they can invest. A firm’s dividend policy may be influenced by its desire to become eligible or remain eligible for this list.