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It must evaluate its profitability and risk to

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Unformatted text preview: 00 ($50,000 $35,000). Growth Prospects The firm’s financial requirements are directly related to how much it expects to grow and what assets it will need to acquire. It must evaluate its profitability and risk to develop insight into its ability to raise capital externally. In addition, the 4. A firm that has an operating loss in the current period can still pay cash dividends as long as sufficient retained earnings against which to charge the dividend are available and, of course, as long as it has the cash with which to make the payments. 568 PART 4 Long-Term Financial Decisions firm must determine the cost and speed with which it can obtain financing. Generally, a large, mature firm has adequate access to new capital, whereas a rapidly growing firm may not have sufficient funds available to support its acceptable projects. A growth firm is likely to have to depend heavily on internal financing through retained earnings, and so it is likely to pay out only a very small percentage of its earnings as dividends. A more established firm is in a better position to pay out a large proportion of its earnings, particularly if it has ready sources of financing. Owner Considerations5 The firm must establish a policy that has a favorable effect on the wealth of the majority of owners. One consideration is the tax status of a firm’s owners. If a firm has a large percentage of wealthy stockholders who are in a high tax bracket, it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payment of taxes until they sell the stock.6 Of course, when the stock is sold, if the proceeds are in excess of the original purchase price, the capital gain will be taxed, possibly at a more favorable rate than the one applied to ordinary income. Lower-income shareholders, however, who need dividend income, will prefer a higher payout of earnings. A second consideration is the owners’ investment opportunities. A firm should not retain funds for investment in projects yielding lower returns than the owners could obtain from external investments of equal risk. If it appears that the owners have better opportunities externally, the firm should pay out a higher percentage of its earnings. If the firm’s investment opportunities are at least as good as similar-risk external investments, a lower payout is justifiable. A final consideration is the potential dilution of ownership. If a firm pays out a high percentage of earnings, new equity capital will have to be raised with common stock. The result of a new stock issue may be dilution of both control and earnings for the existing owners. By paying out a low percentage of its earnings, the firm can minimize the possibility of such dilution. Market Considerations An awareness of the market’s probable response to certain types of policies is also helpful in formulating dividend policy. Stockholders are believed to value a fixed or increasing level of dividends as opposed to a fluctuating pattern of dividends. This belief is supporte...
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