Dividend refers to the portion of net income paid out to shareholders. It is paid in cash and/or stock for making investment and bearing risk. Dividend decision of the firm is yet another crucial area of financial management as it affects shareholders wealth and value of the firm. The percentage of earning paid out in the form of cash dividend is known as dividend payout ratio. A company may retain some portion of its earnings to finance new investment. The percentage of retained in the firm is called retention ratio. Dividend policy is an integral part of the firm's financing decision as it provides internal financing. Dividend policy is concerned with determining the proportion of firm's earnings to be distributed in the form of cash dividend and the portion of earnings to be retained. A firm has three alternatives regarding the payment of cash dividends:
1. It can distribute all of its earnings in the firm of cash dividends,
2. It can retain all of its earnings for reinvestment,
3. It can distribute a part of earnings as dividend and retain the rest for reinvestment purpose.
When dividends are paid to the stockholders the firm's cash is reduced. A firm may decrease its dividend payout and use the retained funds to expand its capacity, to pay off some of its debt or to increase investment. In this way, the firm's dividend policy is closely related with the firm's investment and financing decisions.
Determining the part of earnings to be distributed as dividends is a key decision that affects the value of firm's common stock in the market place. Similarly, the retained earnings are considered to be the most convenient internal source available for financing corporate growth. Thus, every corporate firm should establish and implement an effective dividend policy that leads the firm to stockholders wealth maximization.
It should be recognized that a firm's dividend payout ratio depends on many factors. For example, it may be affected by the volatility in firm's cash flows and changing investment needs over time. If the firm's cash flow is volatile, it may prefer to set a minimum level of regular cash dividends that can be maintained even at low profits. Similarly, if the firm has profitable investment opportunity it prefers to retain more amount by reducing dividend payout ratio.
