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Figure 10.1 The relationship between the cum dividend and ex dividend share prices
Practical constraints
• Liquidity: managers need to consider carefully the effect on the
company’s liquidity position of any proposed dividends.
• A common misconception is that a company with high levels of profits can
afford to pay high dividends.
• Interest payment obligations:
• Dividends are paid out of profits remaining after interest and taxation
liabilities have been accounted for.
• A company’s level of gearing and its interest commitments are therefore a
major constraint on its dividend policy.
Practical constraints (Cont.)
• Investment opportunities:
• Retained earnings are a major source of finance for companies.
• when companies are faced with a number of attractive projects, there is
pressure to reduce dividends in order to finance such projects as much as
possible from retained earnings.
• Factors affecting decision reducing dividend to finance project:
• the attitude of shareholders and capital markets to a reduction in dividends;
• the availability and cost of external sources of finance;
• the amount of funds required relative to the available distributable profits.
Does Dividend policy matter?
• Generally accepted that:
• companies’ dividend policies are relevant to their share valuations.
• One reason: dividends are preferred to capital gains due to their certainty
(the bird in the hand argument).
• According to the argument bird in the hand : “Current dividends, on this analysis,
represent a more reliable return than future capital gains”.