Explain the factors influencing the dividend policy of a company and discuss two common dividend policies with their advantages and disadvantages.
Answer
Dividend policy is influenced by profit stability, cash availability, legal restrictions, market expectations, and taxation; companies may adopt a stable dividend policy or a residual dividend policy, each having its own pros and cons.
Step-by-step solution
- List the major factors that affect dividend decisions: profitability, cash flow, legal constraints, shareholders' expectations, and tax considerations, because each factor determines how much profit can be distributed.
- Describe the stable dividend policy: the company aims to pay a constant dividend per share irrespective of earnings fluctuations; advantage – provides predictable income to shareholders; disadvantage – may force the firm to retain earnings or borrow when earnings fall.
- Describe the residual dividend policy: dividends are paid out of earnings left after financing all profitable projects; advantage – aligns dividend payout with investment opportunities and preserves cash for growth; disadvantage – dividend amounts vary each year, creating uncertainty for investors.
Common mistake: Mentioning only profit level and ignoring cash flow or legal constraints when explaining dividend decisions.
Concept tested: Dividend policy and its determinants
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