Dividend Policy Formulation

While formulating its dividend policy a firm should bear in mind the following considerations:

  1.  Investment decisions have the greatest impact on value creation.
  2. External equity is more expensive than internal equity (retained earnings) because issue costs and underpricing.
  3. Most promoters are averse to dilute their stake in equity and hence are reluctant issue external equity.
  4. There is a limit beyond which a firm would have real difficulty in ranting debt financing.
  5. 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:

  1. Don’t pay dividends at the expense of positive NPV projects.
  2. Minimize the need to sell external equity.
  3. 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.
  4. Accept temporary departures from the target dividend payout ratio and the target, debt-equity ratio.
  5. Avoid dividend cuts.
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