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Companies' dividend policy

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  1. Background on dividends and three basic theories
    1. Background
    2. Irrelevance of Dividend Policy
    3. Tax Preference Theory
    4. The Bird-in-the-Hand Theory
  2. Dividend policy in practice
    1. Confusion of Empirical Tests and Factors That Influence Dividend Policy
    2. Setting a Dividend Policy

The dividend policy is one of the most important financial policies, not only from the viewpoint of the company, but also from that of the shareholders, the consumers, the workers, regulatory bodies and the Government. For a company, it is a pivotal policy around which other financial policies rotate. The value of the corporate securities depends, to a great extent, on the dividend. Thus, in deciding upon the financial structure of a company, the dividend needs to be assigned due consideration.
Once a company makes a profit, the board of directors must decide what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends.
Once a company decides to pay dividends, a somewhat permanent dividend policy should be established, which would impact on investors, and the perceptions of the company in the financial markets, by providing information concerning the firm's performance. The choice of the appropriate dividend policy depends on the preferences of investors and potential investors as well as on the company's capital structure and its future plans.

[...] In fact there is no a single effective dividend policy it varies accordingly to the country with different taxation systems, to industry, to the size and the form of a company, to company's investment needs, to the type of firm's investors, etc. Optimal dividend policy strikes a balance between current dividends and future growth that maximizes the firm's stock price. In order to set a stable and effective dividend policy each company should: Forecast its capital needs over a planning horizon, often 5 years; Set a target capital structure; Estimate annual equity needs; Set target payout based on the residual model; Maintain target growth rate if possible, varying capital structure somewhat if necessary. [...]

[...] PARAGRAPH II DIVIDEND POLICY IN PRACTICE Confusion of empirical tests and factors that impact dividend policy We have just seen three theories that describe dividend policy from different sides. According to the irrelevance theory, any payout is correct; tax preference theory proves that lower payout is better; and bird- in-the-hand theory argues to set higher payouts. But which theory, if any, is correct? Empirical tests have tried to relate stock prices or P/E (price-to- earnings) ratios to dividend payout. If we could find a sample of companies that varied only with respect to their payout policies, then we could plot P/E's and prices against payout, and if the pattern that emerged was like one of those shown in the following graphs, then this would support one of the theories. [...]

[...] Thus it is possible that a company's stock price might be higher under one dividend policy than another. Both signaling and clientele effects impede empirical tests - they make it harder to understand whether investors in the aggregate prefer dividends or retention. Also, different groups of investors are likely to prefer different policies. Therefore, if a firm changes its policy, some investors will like it while others will dislike it; and it may look like investors are indifferent when they really care, but in opposite directions. [...]

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