Discuss the factors which a company may need to take into consideration when determining their dividend distribution and identify the three most commonly used dividends distribution policies.
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Discuss the factors which a company may need to take into consideration when determining their dividend distribution and identify the three most commonly used dividends distribution policies. A dividend policy is the plan of action adopted by the directors of a company whenever it is decided whether to distribute a company's profits as payments to individual shareholders. The decision of dividend policy is the responsibility of a company's directors. Under UK company law, directors cannot be forced to recommend a dividend and the shareholders cannot vote themselves a higher dividend than that recommended by the directors, although they may vote for a lower one. There are a number of factors that may influence a company's decisions regarding dividend distribution. One of these factors is profitability. The 1985 Companies Act prevents distribution of dividends from sources other than distributable profits; therefore, if a company is not profitable then it will not be able to pay dividends. A company with liquidity problems will also have difficulties in sustaining dividend payments. A company should also take tax issues into consideration when determining its dividend policy. Income from dividends and the capital gains that are realised when shares are sold may attract different rates of tax. The different rates will affect whether shareholders will prefer cash dividends or for the money to be reinvested to enhance the value of the company and the share.
The danger with this type of policy is that if earnings fall in any given year, it may send out the wrong signals to the market and lead to shareholders selling shares and falls in the company's share price. Constant dividend per share is when a fixed sum is paid out every year. The dangers of this approach are that the dividend will either become frozen at a low level that will discourage new investors, or directors will be reluctant to reduce payments even when it is practical to do so because they fear that shareholders and investors will interpret their action negatively. Low regular dividend with periodic enhancements is a payment of a small regular dividend, supplemented in high earnings years by an enhanced dividend as part of the final dividend payment. Although this policy offers the shareholder certainty of a regular income and allows the company flexibility in dividend policy, there is a danger that the enhanced element will become part of the shareholders' expectation. There are a number of theories surrounding dividend policies. It is often questioned whether dividend policies are important in terms of influencing share value. If dividend policy is influential, it is important to decide on the optimal dividend policy of what proportion of earnings should be distributed as dividends, or retained for other purposes, to maximise a company's share value. One of the theories relating to dividend policy is the residual theory of dividend policy.
A rise in dividend payment is generally viewed as a positive signal about a company's future earning prospects. A decrease in dividends is viewed as a negative signal, resulting in a decrease in share prices. This may be why many companies choose to adopt a constant dividend policy. The Bird in the Hand theory suggests that shareholders are adverse to risk and prefer dividend payments to reinvestment because any capital growth that this promotes will only take place in an uncertain future. Agency cost theory states that agency costs are incurred as a means of resolving the agency problem that arises from the managers of a company being a distinctly separate group from the shareholders who expect the agents to act on their behalf. From looking at the figures presented by EMI, I would infer that the dividend policy used by the company is the constant dividend per share policy. This is because that despite the company's profits decreasing rapidly throughout the years, the dividends have always remained constant. EMI may wish to keep their dividends constant to prevent shareholders from selling their shares and to keep share prices up. It will also aid them in attracting new investors. This relates to the dividend signalling theory. The company may not be able to increase their dividends to keep share prices up and do not want them to decrease, so instead they keep the dividends constant to promote a positive future for the company.
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