Dividend policy refers to the strategy that a company takes when it comes to structuring the dividends that they pay to shareholders. Of course, it may be the case that a company will decide to offer no dividend at all.
Dividend policy is important as it should match the preferences of the shareholders of a company. It should also meet the goal of maximising shareholder wealth. It is therefore a key decision that defines the agency relationship between the management of the company and the shareholders.
In the circumstance that shareholders have a preference for receiving dividends, the management of the firm have a responsibility to ensure that the dividend is affordable and will not jeopardise the future of the company. Likewise, if shareholders have a preference to receive no dividend, the management of the firm should not proceed to offer a dividend, unless there is no other good use for the money. If there are no new projects to invest the money into, then the best decision is to pay the excess cash out as a dividend, as it would be the best way to maximise shareholder wealth.
Dividend signalling is a theory that states that the management of a company use dividends to signal their expectations for future growth. If the future prospects for growth are positive, it is thought that the management of a company will signal this message to shareholders by increasing the dividend payment. Likewise, if the future prospects for growth are negative, the management of the firm will reduce the dividend payment.
This happens due to the fact that the management of the company and shareholders have access to different information. The management of the firm have access to insider information, which is illegal for shareholders to use.
This is a problem because shareholders do not always have an idea of what is happening inside of the company that they are investing in. So, to overcome this issue, dividends are used to signal positive or negative expectations for growth.
There are three main types of dividend policy. The first type is called the stable dividend policy and it is the mostly commonly used. As the name suggests, the aim of the policy is to deliver consistent dividends to shareholders that are the same every year. That way the shareholders know how much they can expect to earn in dividends from that stock each year.
The second type is called the constant dividend policy and it involves a company paying the same percentage of their earnings as a dividend each year. This means that the dividend that shareholders receive may be totally different each year. If earnings increase, they will receive a higher dividend payment, but if earnings fall, they will receive a smaller dividend. For example, a company may decide to pay 50% of their earnings as a dividend each year, regardless of how much they earn.
The third type of dividend policy is called the residual dividend policy and it involves a company paying out a dividend after they have paid for their expenses and working capital. In many ways, this is the best approach to receiving dividends as it ensures that the company has the flexibility to meet its expenses, rather than paying a fixed amount as a dividend each year.
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