The Decision to Pay Dividends - Coursework Example

The Decision to Pay Dividends Name Institution Tutor Date Introduction Dividends often refer to the cash paid out by the organization to its shareholders or investors. If the firm makes payment using other sources apart from accumulated or current retained earnings, then the term distribution is often used rather than dividend. However distribution from earnings can be referred to as dividend. More specifically, direct payment by the firm to its shareholders and investors may be regarded as dividend. There are different types of dividend. The key forms are, cash dividend, special dividend and extra dividend (Bhat, 2008). The decision by the firm to pay dividend to the shareholders is greatly relevant to the real world. Additionally, before paying dividends to its shareholders, there exist certain factors that the firm need to consider. This paper explores how the extent to which the decision to pay dividends by companies is relevant to the real world. The scope of the paper analyses key factors which management need to consider when determining the timing and size of the firms next dividend payment. Extent to which the decision to pay dividends by firms is relevant in the real world Dividends paid by companies are seen positively by the companies and investors. Companies which do not give dividends are rated negatively by the investors thus impacting its share price. Individuals who support the relevance of dividends to real world clearly indicate that dividends lowers uncertainty of the shareholders. For instance, company’s earnings are discounted at a reduced rate thus increasing the company’s market value ijn the real world. Essentially, the decision of the company to give or not to give dividends relies on whether the organization has enough chance to invest their retained earnings (Frankfurter, 2003). The dividends given to the shareholder is important and makes the shareholder to make more returns. Walter’s model claims that, shareholders reinvest dividends paid to them by the company and gain more returns. Thus the shareholders are able to improve their living standards from the dividends paid to them by the firm. Additionally, investors are able to calculate the value of the firm from the dividends it offers to its shareholders. The dividend discount model is a formula explaining the value of a share. The model claims that, a share is worth the amount of all potential dividends payments. Dividends are forms of cash flow to the shareholders and investors; they are also vital reflection of the firm’s value. Thus the organization is capable of attracting the trust of many investors in the real world (Helminen, 2010). Additionally, dividends act as real actual income for the investors and shareholders. Dividend is the only return that shareholders and investors receive when they purchase stock. One of the key importances of dividend payment is that, they provide shareholders with consistent flow of income on a quarterly basis. Without dividend payment, many shareholders and investors would earn no income (Lichtenfeld, 2015). In general, dividend payment enables the shareholders and investors to face the real world with confidence since they have enough funds to earn a living. Key factors which management should consider when determining the size and timing of a company's next dividend payment? Before determining the size and timing of dividend payment, there are several factors that the organization needs to consider. The first factor is income stability of the organization. Income stability of the firm is one of the key factors determining dividend policies in firms and organization. More specifically, established organizations with predictable and stable income streams are likely to give out dividends than firms with volatile or growing incomes. Rapidly growing firms rarely give out dividends since they prefer investing their profits back into the firm to fuel future growth and development of the organization. Organization with unstable income streams fail to pay dividends or pay small amount of dividends in order to ensure the payment will be sustainable. It always looks terrible to shareholders when firms are forced to reduce or suspend their dividend payment. Thus, income stability is a vital factor impacting the decision by the organization to pay or to give out dividends (Weygandt, 2010). Nature of the business is also an important factor in determining the size and timing of dividend payment by the organization. Firms with stable earnings may adopt more consistent and stable dividend policy, they are able to pay dividends more frequently to its shareholders those firms with unstable earning since they are able to predict their earnings. Organizations focusing on necessities often suffer less from stable earnings than companies involved in luxury goods. Companies with stable earnings are capable of adopting a high or more stabke dividend policy, while other companies with instable income earnings should formulate low income polices (Bhat, 2008). The other factor impacting the decision of the firm is whether the organization can utilize its profits gained for better use. The possibility for better returns through capital reinvestment is another factor affecting the ability of the organization to offer dividends to its shareholders. Generally, if the organization feels that it would be in the best interest of its investors and shareholders to use its profits for other activities apart from paying dividends, it can chose not to give out even if its revenues are predicable and stable. An example is Warren Buffett’s Berkshire Hathaway company which has not paid dividends to its shareholders. Instead, the firm feels that, it is better to re invest company profits. As a result, the organization has realized phenomenal results. The possibility of reinvesting profits can make the firm to lower or stop its dividend payments and channel the profits into more investments, thus increasing the operations of the organization (Baker, 2009). Again, tax considerations are another factor affecting the decision of the organization to pay and not to pay dividends to its shareholders. Dividends are often taxed twice. The first taxation is at the corporate level and the next taxation is when they are being paid to shareholders. Due to this, several organizations feel that it is most effective and efficient to use other strategies of returning capital such as share purchases. Repurchasing of shares possesses similar net effect as dividend payment, the intrinsic value of the firm’s shares rises as the share count of the firm drops. However, this can enable many investors to invest their dividends without worrying about dividend taxes (Weygandt, 2010). Again, before determining the timing and size of dividend payment, the organization should consider their age. The age of the firm has more effects on distribution of its profits as dividends. A new and growing firm may need mush of its earning for financial expansions and for its growth. Thus, the organization is likely to follow low and rigid dividend policy where it utilizes most of its earnings for development and growth. However, an old firm with good name and good track record in the public can formulate and adopt a more consistent dividend policy. Such organization can decide to pay up to one hundred percent dividend payout ratio. Such organization can pay dividends to its shareholders and investors more frequently (Bhat, 2008). Also, the firm need to consider its liquidity position before determining the size and timing of its next dividend payment. Usually, dividends are often paid in terms of cash, thus, it entails cash. Organization may have enough profits to declare dividend but it lacks enough cash to pay dividends. Hence, availability of cash within the firm and sound financial position of the company is a vital aspect in making dividend decision. The liquidity of the firm relies on its investment and its financial decisions. If the cash position of a company is week, then stock dividend will likely to be better and if the cash position of the firm is good, then it can go for dividend payment by cash (Bhat, 2008). The final factor impacting the dividend policies of the organization is economic conditions in the market environment. If there exist a trouble in one sector and the profits are anticipated to decline, is common for organizations to be very defensive in their dividends. This is currently evident in energy sector. There exist low oil prices which has created havoc on many firm’s profitability, this has made several firms to reduce their dividends recently. Thus the organization can be greatly impacted by economic conditions in its environment (Weygandt, 2010). Conclusion The bottom line is that dividend payment by the organization matters a lot and greatly relate to the real world. Through giving out dividends to its shareholders and investors, the firm makes it possible for the shareholders to make more returns through reinvesting the dividends hence improving their living standards in the real world. Additionally, the investors and shareholders are able to calculate the value of the firm. There exist several factors that the firm should consider when determining the size and timing of its next dividend payment. The firm should consider its income stability, how best it can utilize its profits other than paying dividends, tax considerations and economic conditions in the market environment. References Baker, H. K. (2009). Dividends and dividend policy. Hoboken, N.J: John Wiley Bhat, S. (2008). Financial Management: Principles and Practice. New Delhi: Excel Books Frankfurter, G. M., Wood, B. G., & Wansley, J. W. (2003). Dividend policy: Theory and practice. San Diego, CA: Academic Press. Helminen, M. (2010). The international tax law concept of dividend. Austin [Tex.: Wolters Kluwer Law & Business Lichtenfeld, M. (2015). Get rich with dividends: A proven system for earning double-digit returns. Weygandt, J. J. (2010). Accounting principles. Mississauga, Ont: J. Wiley & Sons Canada. Read More