What do you understand by stable dividend policy? Why should the firms
follow it?
The stable dividend policy is the easiest and most commonly used policy. The goal of the policy is to aim for steady and predictable dividend payouts every year, which is what most investors are seeking. When earnings are up, investors receive a dividend. When earnings are down, investors receive a dividend. The goal is to align the dividend policy with the long-term growth of the company rather than with quarterly earnings volatility. This approach allows the shareholder to have more certainty around the amount and timing of the dividend.
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It is one of the most significant sources of financing for the firm in terms of raising funds to undertake investments. Dividends are generally paid in cash. Thus the distribution of earnings uses the available cash funds of the firm.
Dividend policy of the firm, thus, affects both the long-term financing and the wealth of shareholders. As a result, the firm’s decision to pay dividends may be shaped as a long-term financing decision and as a wealth maximisation decision.
The view that dividends are irrelevant is not correct, once we modify the assumptions underlying this view to consider the realities of the world. In practice, every firm follows some kind of dividend policy.
The typical dividend policy of most of the firms is to retain a portion of the net earnings and distribute the remaining amount to shareholder.
A. Stability of Dividends:
Stability or regularity of dividends is considered as a desirable policy by the management of most companies. Shareholders also generally favour this policy and value stable dividends higher than the fluctuating ones. All other things being the same, stable dividends have a positive impact on the market price of the share.
Stability of dividends sometimes means regularity in paying some dividend annually, even though the amount of dividend may fluctuate from year to year and may not be related with earnings. There are a number of companies which have records of paying dividend for a long unbroken period. More precisely stability of dividends refers to the amounts out regularly. Three distinct forms of such stability may be distinguished.
1. Constant dividend per share:
A number of companies follow the policy of paying a fixed amount per share as dividend every year, irrespective of the fluctuations in the earnings. This policy does not imply that the dividend per share will never be increased.
When the company reaches new levels of earnings and expects to maintain it, the annual dividend per share may be increased.
The dividend policy of paying a constant amount of dividend per year treats common shareholders somewhat like preference shareholders without giving any consideration to investment opportunities within the firm and the opportunities available to shareholders.
This policy is generally preferred by those persons and institutions that depend upon the dividend income to meet their living and operating expenses, increases and decreases in market values may even be of little concern to these investors, and this condition tends to produce a steady long-run demand that automatically stabilizes the market value of the share.
2. Constant percentage of net earnings:
The ratio of dividend to earnings is known as payout ratio. Some companies follow a policy of constant payout ratio,
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