Constraints Affecting Dividend Payouts - Case Study Example

Constraints Affecting Dividend Payouts Introduction Dividend policy of a company is an important matter in terms of establishing creditability of the company among stakeholders and investors as the goal of every management is to enhance the firm’s value. There are different views with regard dividend payout policy. Some say that dividend policy is irrelevant for raising the value of the firm under the assumptions of no transaction costs, no taxes, and no agency cost. Many believe that high dividend increase the stock value as dividend is more predictable than the capital gain; while others feel that low dividend policy increases the stock value as after tax returns are more than high dividend payout policy. Different dividend policies have different reactions. The determination of dividend policy is a sensitive issue and dependent upon a number and variety of factors or constraints surrounding the company and capital market. In this write up such different factors that affect in determination of dividend payout policy have been examined basically with a view to establish or find out the best approach to determine a suitable dividend payout policy. The factors that mostly affect the dividend policy of the company are legal constrains, contractual obligations, company’s internal constrains, growth prospects of the company, market factors, and owners’ considerations. Legal Constraints A legal constraint is “a source of potential divergence between corporate payout policies in emerging and other markets arises from possible restrictions on the maximum or minimum amounts that companies payout to shareholders and from constraints on how these payments may takes place.”(H.Kent Baker, page 500)i. Legal constraints on minimum or maximum dividend payouts by a company are one of the major factors affecting the dividend policy of a company. Every state is concerned about the safety of investors, creditors, and others connected with the affairs of corporate bodies in order to maintain healthy economic conditions. Accordingly states make laws putting certain restrictions on the companies in respect of declaration of dividends to its stakeholders. For example, some states prohibit companies from distributing dividend in cash of any portion of its legal capital. Legal capital is often considered by state laws as the par value of the equity or common stocks. There are many states that also consider premium (paid in capital in excess of par value) paid as part of legal capital besides the face or par value of common stock, and put restriction in paying out cash dividend in excess of that par value and premium paid on shares. These restrictions are called capital impairment restrictions. The basic idea behind such capital impairment restrictions is to safeguard the interests of creditors. The companies should have enough capital bases to make the creditors feel secured so that their claim is protected legally. Assuming the capital structure and retained earnings of X & Co. are as under and the company is registered in a state where legal capital is treated as par value of equity shares: Amount/$ Equity share capital 200000 Share premium (Paid in capital excess of par value) 400000 Retained earnings 280000 Total shareholders’ equity 880000 In such a state the X & Co. can pay cash dividend only up to $680000, which is the part of shareholders’ equity barring par value of equity shares. Under such a situation the company is not impairing its capital. But if the law of the state stipulates that legal capital includes all paid in capital, then X & Co. can declare cash dividend only up to $280000 that is value of retained earnings. There can also be another type of legal restriction that limits the dividend amount up to current and past retained earnings. For example in above case X & Co. has $60000 available out of current earnings for dividend to equity shareholders and the also the company has past retained earnings of $280000, then legally the company can declare and pay dividend up to the limit of $340000. It is seen that many state prohibits the companies from paying cash dividend when company is bankrupt or insolvent. There may a situation where taxation department asks the companies to deduct the tax liabilities from retained earnings before considering those retained earnings for the purpose of distribution as dividend to shareholders; and tax the amount if a violation is made of this rule. Take the case of X & Co., if the company has tax liability of $40000 and the retained earnings are $280000, then available balance for out of these retained earnings for paying dividend is only $240000. If the company makes a violation and pay say $260000 as dividend to shareholders, then the tax department will levy taxes on additional income of $20000, and may be penalties when prescribed for in the law. Contractual constrains It is seen that restrictive provisions in a loan agreement put various types of restrictions on payment of cash dividends. Mostly these restrictions prohibit the cash payouts of dividend till a certain level of earnings has been achieved by the company. Normally the restrictions are described as percentage to the current or retained earnings. The purpose of such contractual restrictions is to safeguard the interests of creditors. “these contractual constraints exist to protect creditors. Any disregard can provide grounds for immediate payment of loans to creditors.” (Angelico A. Groppelli and Ehsan Nikbakht, page 274)ii Contractual restrictions are generally stated or formed in the contracts or agreements and mostly take the following forms: Agreements may contain a maximum ceiling limit rate and with the effect the company cannot declare and pay dividend exceeding that ceiling rate. Some time the agreements provide restrictions on the maximum amount or sum on dividend payouts instead of maximum rate of dividend. It is also seen that agreements contain clauses where a minimum ceiling is fixed on the retained earnings and beyond that amount the company can declare the dividend up to the amount in excess of that minimum limit. Also firms enter into contracts where firms undertake not to pay dividends if current ratio or the interest coverage ratio or any other ratio fell below an agreed level. These safeguards provided by under contractual agreements play a vital role in protecting the interests of the creditors. The companies find it difficult to disregard such contractual restriction. This is because any violation of agreements may force creditors to seek recovery of the loan or other facilities provided to the company and such repayments may jeopardize the finances of the company affecting the working capital. Accordingly the companies have to consult their legal advice before declaring or paying out dividends to shareholders. Precisely the contractual constraints are another type of legal constraints as they affect the regular operations of the company and its working capital. Internal Constraints Internal constraints on dividend payouts concern the ability of the concern to release its liquid funds (cash and marketable securities) funds for the payout. When there are liquidity problems, a company may indulge in borrowing funds for the purpose of dividend payout; but is seen that firm may find difficult to get borrowings for dividend payouts as the company might find it difficult to offer tangible securities for the borrowings under the circumstances of liquidity crunch. Withdrawal of liquidity for dividend payouts certainly dent the working capital and firms generally take such actions only when liquidity flow is at ease. Take the earlier case of X & Co. Assuming as per state regulations legal capital is defined as entire paid up capital. Under such situation the company can pay dividend up to $280000. Suppose the company has liquidity of $100000, out of which $40000 is available in cash and $60000 is available as marketable securities. Further the company requires $700000 for its normal working as part of working capital. Under such a situation the company can pay only up to $ 30000 as dividend. This is a situation of internal constrains and if the company indulges in dividend payout of more than $30000, either its working capital will be affected or the company will have to arrange borrowings for the purpose of dividend payouts. Growth Prospectus “The dividend policy is also affected by the owners’ consideration of (a) the tax status of the shareholders, (b) their opportunity of investment, and (c) the dilution of ownership. It is well- nigh impossible to establish a policy that will maximize each owner’s wealth. The firm must aim at a dividend policy which has a beneficial effect on the wealth of majority of the shareholders.”(Khan and Jain, page 31-9)iii Every company under normal circumstances has growth plans and naturally growth has financial considerations. One can say growth of a firm is directly related to availability of finances with the firm. The firm has to design growth plans keeping in view the availability of funds that are free from routine requirements. The company can also explore external sources for its capital investment requirements for growth plans. Again the firm has to consider risk factors before considering the outside support of availability of funds. In other words initially every firm will try to explore its internal resources of funds for its growth investment requirements. Dependence on internal resources from say retained earnings put constraints on dividend payouts. This is because after meeting the growth requirements only a small percentage of funds are left for the purposes of dividend payouts. That means only well established firms find it easy to meet both growth requirements and dividend payouts, whereas a not so well established but growing firm finds it very difficult for meeting the demands of dividend payouts The considerations of owners The rule of the game is that every firm should frame its dividend payout policy that has favorable impact on the wealth of stakeholders. Suppose most stakeholders are wealthy and their income attract high rates of taxation. Keeping in view such status of the stakeholders, the company may delay the payment of dividend to stakeholders in order to reduce their tax liabilities. The company may also wait for dividend payout till such stakeholders dispose of their share holdings. The company has another option of making dividend payouts in small proportion But when the stakeholders are in lower tax rate group, the company will not hesitate in making large dividend payout as the tax liability because of such payouts will not be higher because of otherwise lower income of the stakeholders. Another important consideration of the owners in respect of dividend payouts is owners’ investment opportunities. If the owners earn more in prospective external investments by taking the same amount risk as in the firm, the firm may make higher dividend payouts to enable the stakeholders to explore outside investment opportunities. On the other hand if the firm investment opportunities are better than external investments, the firm may not make higher dividend payouts. Then there is a consideration of potential dilution of ownership. When the company makes higher dividend payouts the investment in the firm/s shares becomes attractive. The firm may face the situation of raising fresh capital because of higher dividend payouts. With the results increased shareholding will dilute the control and earnings of the present stakeholders and this may not be liked by existing stakeholders. Accordingly potential dilution of ownership is very important consideration or constraint in dividend pay outs. Market Considerations It is observed that stakeholders believe in a fixed or increasing level of dividend. They are also interested in continuous dividend payouts as these considerations eliminate the uncertainty element of the frequency of dividend payouts. Moreover increasing and continuous payouts increase the market price of shareholding and thereby the wealth of the shareholders. There is another market consideration is about the information of company performance. Continuous and increasing dividends provide signals that company is on the roads of success and growth. Investors flock in whenever there is offering from the company. Moreover “owners and investors generally construe a dividend payment during a period of losses as an indication that loss is merely temporary.” (Lawrence J. Gitman page 601)iv Best approach of setting dividends Dividend policy is affected by the constraints like legal, contractual, internal impacts and problems, growth plans, objectives of maximizing wealth of shareholders, and market considerations. The dividend payout should not touch the legal capital as defined under law. Contractual commitments put various types of restrictions on dividend payout policy in order to safeguard the contractual objectives. Internal constraints are the results of shortage of cash availability for dividend payments. Growth plans has greater importance for retained earnings rather than the dividend payouts. Taxation issues of owners often control the size and timings of dividend payouts. Market considerations play a role keeping in enhancing the market price of the shares. The real impact of dividend payout is on cash outflow affecting working capital. Also the company feels the needs of raising finances externally when larger dividend payouts are charged to retained earnings. Accordingly a company’s dividend payout policy should provide for sufficient financing and also aims at maximizing the wealth of its shareholders. It is seen that size and timings of dividend payouts affect the market prices of shares. Therefore the management has to take the decisions keeping in view the real constraints being faced as well as the long term objectives of the firm. The dividend payment policy should always be a long term policy. The policy should be consistent keeping in track with ultimate aim of maximization of market prices of the shares of the company. Financing problems are automatically resolved when prices of shares of the company are riding high and in attaining such a situation, the dividend payouts have pertinent role to play. There is always a best approach keeping in view the impacts of constraints and long term objectivity of the company. Word Count: 2340 References: Read More