Once a company makes a profit, it must decide on what to do with those profits. They could continue to retain the profits within the company for capital investment, or they could pay out the profits to shareholders (the owners of the company) in the form of dividends. The dividend policy decision involves two questions:
How much it should pay to shareholders from profits on average? And 2) what type of dividend policy should the company follow? I.e. Problems such as whether it should maintain stable dividend policy or a policy increasing dividend growth rate etc. On the other hand Management has to satisfy various stakeholders from there hard earned money. Out of all the Stakeholders priority should be given to equity shareholders as they are facing the high risk on their investment.
The company's Board of Directors makes dividend decisions. They have to make the decision between issuance of dividend or to reinvest the cash into new projects so that they enhance the earning capability of company. The tradeoff between paying dividends and retaining profits within the company the dividend policy decision is actually a trade-off between retaining earnings v/s paying out cash dividends.
Dividend policies should always consider two basic objectives:
· Maximizing owners' wealth
· Providing sufficient financing for the company while determining a firm's dividend policy, board of directors must find a balance between current income for stockholders (dividends) and future growth of the company (retained earnings).
In applying a dividend policy within the company, management must consider the following two issues
· How much cash is available for paying dividends to equity investors, after meeting all the needs of debt payments, capital expenditures and working capital and so on.
· To what extent are good projects available to the firm (i.e. Return on equity - ROE > Required Return)
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