Dividend Policy - Dividend Policy This lecture deals with...

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Dividend Policy This lecture deals with the process and procedures that firms employ in the determination of an appropriate dividend policy. Of chief concern is how much of the firm’s earnings should be distributed to the shareholders. I. Dividend payout ratios vary considerably across industries and even within an industry. Dividend decisions are affected by consideration of a number of issues concerning legality, bond indenture provisions, tax aspects, liquidity considerations, borrowing capacity, earnings prospects, growth requirements, the inflation outlook, shareholder preferences, and dilution effects. A. Most states impose three types of regulations on the payment of dividends by firms that are chartered in that state. 1. The capital impairment restriction stipulates that dividends cannot be paid out of capital. Depending on the state, capital is defined as either the common stock account or that account together with other contributed capital in excess of the par value of the common stock. 2. The net earnings restriction stipulates that dividends must be paid only out of present and past net earnings. 3. The insolvency restriction states that dividends cannot be paid when a firm is insolvent, when the firm's liabilities exceed its assets. This is to protect the creditors of the firm. B. Restrictive covenants in bond indentures, loan agreements, lease contracts, and preferred stock agreements may prohibit or limit dividend payments. C. Previously, the Revenue Reconciliation Act of 1993, the maximum capital gains tax rate is 28 percent, while the marginal tax rate on dividend income can be 39.6%, 35%, and 31% for certain high income individuals. But now under the 2003 Tax Act dividends will be taxed at a maximum 15% and the capital gains tax for individuals is taxed at a maximum of 15%. . D. The IRS code prohibits excessive accumulation of profits for the purpose of protecting stockholders from paying taxes on the dividends that they would otherwise receive. A tax is imposed on these excessive accumulations. E. Payment of dividends requires liquidity, i.e., cash. Firms with substantial cash flow and liquidity are more able to pay dividends. 1
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F. Available investment opportunities together with the availability of capital may dictate that earnings be retained in the business rather than paid out as dividends. G. Firms are often reluctant to lower their dividend payments once they are established. Firms with stable earnings are able to pay higher dividends without risk of cutting them than are firms with unstable earnings. H. Firms in rapid growth industries with a substantial need for capital must frequently retain earnings for investment or face the higher cost of external equity capital. I. In closely-held corporations, shareholder preference plays a more important role in the dividend decision.. If the majority of shareholders are in the high marginal tax bracket, they may favor a policy of high earnings retention over a policy of high dividend payout.
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