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Dividends are payments made by a corporation to its shareholder members.

It is t
he portion of corporate profits paid out to stockholders. When a corporation ear
ns a profit or surplus, that money can be put to two uses: it can either be re-i
nvested in the business (called retained earnings), or it can be paid to the sha
reholders as a dividend. Many corporations retain a portion of their earnings an
d pay the remainder as a dividend.
For a joint stock company, a dividend is allocated as a fixed amount per share.
Therefore, a shareholder receives a dividend in proportion to their shareholding
. For the joint stock company, paying dividends is not an expense; rather, it is
the division of an asset among shareholders. Public companies usually pay divid
ends on a fixed schedule, but may declare a dividend at any time, sometimes call
ed a special dividend to distinguish it from a regular one.
Cooperatives, on the other hand, allocate dividends according to members' activi
ty, so their dividends are often considered to be a pre-tax expense.
Dividends are usually settled on a cash basis, store credits (common among
l consumers' cooperatives) and shares in the company (either newly-created
s or existing shares bought in the market.) Further, many public companies
dividend reinvestment plans, which automatically use the cash dividend to
ase additional shares for the shareholder.

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Several factors must be considered when establishing a firm's dividend policy. T


hese include
The liquidity position of the firm - just because a firm has income doesn't mean
that it has any cash to pay dividends.
Need to repay debt - oftentimes there are negative covenants that restrict the d
ividends that can be paid as long as the debt is outstanding.
The rate of asset expansion - the greater the rate of expansion of the firm, the
greater the need to retain earnings to finance the expansion.
Control of the firm - if dividends are paid out today, equity may have to be sol
d in the future causing a dilution of ownership.
Legal Considerations:
Technically, it is illegal to pay a dividend except out of retained earnings. Th
is is to prevent firms from liquidating themselves out from underneath the credi
tors.
Internal Revenue Service Section 531 - Improper Accumulation of funds. This is t
o prevent individuals from not paying dividends in order to avoid the personal i
ncome taxes on the dividend payments.
Is it in the best interests of shareholders to pay out earnings as dividends or
to reinvest them in the company? The answer to this depends upon the investment
opportunities that the firm has.
There are three fundamental policies to paying cash dividends that firms employ:
Pay a constant dollar amount each year regardless of earnings per share. This is
what most firms do.
Use a constant payout ratio (for example, 50% of EPS)
Pay a low, fixed dividend amount plus "dividend extras" or "special dividends".
This allows the company to avoid having to cut dividends since the basic dividen
d is low, but also avoids the improper accumulation of funds during good years.
A cut in dividends generally hurts a stock's price because it sends a signal to
stockholders that management?s outlook for the future is that the company cannot
continue to pay the dividend. Most companies therefore start off with a low div
idend and only increase it when they feel that the earnings prospects have impro
ved sufficiently to allow for maintaining a higher dividend. Many companies will

even borrow money in a bad year in order to avoid cutting the dividends.
The market price is influenced by dividends through what is called the ?clientel
e? effect. That is, some investors want dividends (such as retirees and pension
funds) while others do not want dividends (wealthy individuals) but would prefer
capital gains (which are taxed at a lower rate and deferred).
Flotation costs encourage a company to retain earnings in order to minimize havi
ng to sell additional stock in the future. As we saw in the cost of capital calc
ulations, the flotation costs make new equity more expensive than retained earni
ngs.
Some companies pay no dividend. Why? Because they have good investment opportuni
ties and reinvest the earnings.