While formulating its dividend policy a firm should bear in mind the following considerations:
- Investment decisions have the greatest impact on value creation.
- External equity is more expensive than internal equity (retained earnings) because issue costs and underpricing.
- Most promoters are averse to dilute their stake in equity and hence are reluctant issue external equity.
- There is a limit beyond which a firm would have real difficulty in ranting debt financing.
- The dividend decision of the firm is an important means by which the management conveys information about the prospects of the firm.
Following guidelines emerge from the above considerations:
- Don’t pay dividends at the expense of positive NPV projects.
- Minimize the need to sell external equity.
- Define a target dividend payout ratio along with a target debt-equity ratio, taking into account the investment needs, managerial preferences, capital market norms and tax code.
- Accept temporary departures from the target dividend payout ratio and the target, debt-equity ratio.
- Avoid dividend cuts.
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