Factors Affecting Corporate Dividend Policy Decisions

Factors that affect a company’s dividend policy decision include:

Taxation

• Investors are primarily concerned with the after-tax returns of their investments.

• Differences in tax rates for dividends versus capital gains can materially influence an investor’s stock investment choices.

• In addition, frequent dividends create frequent tax events, while capital gains taxes can be deferred until an investor decides to sell a stock.

• Tax systems affecting dividends can be divided into three general classes:

• Double Taxation System: this occurs in the U.S., where the company pays taxes on its earnings prior to any dividend distribution and investors receiving dividends pay taxes on dividend income.

• Split Rate System: earnings paid as dividends are taxed at different rates from earnings retained by the company.

• Imputation System: companies pay corporate income taxes, but shareholders can subtract the portion of taxes paid by the company from their individual tax bills.

Flotation Costs of Issuing Equity

• When issuing new stock, companies must pay investment banking fees.
• As a result of these costs, firms may hesitate to pay dividends if they anticipate financing needs for upcoming capital projects.  In other words it is less expensive for a firm to reinvest its earnings, rather than pay a dividend and face the prospect if issuing new equity.

Dividend Restrictions

• Dividend payments reduce a company’s retained earnings, which in turn reduce equity.
• Companies may be constrained by debt covenants from paying dividends if shareholder equity falls below a specified level, for example.

The Clientele Effect

• Investors face different financial situations, which lead to different attitudes toward dividends.
• A key difference across investors is tax status.  A high tax bracket individual may not value dividends as much as a tax exempt charity.
• Some institutional investors, such as mutual funds, pension funds, banks, or insurance companies may only buy stocks which have a record of steady dividends, as the equity of these dividend paying companies is viewed as less risky.
• Investor preferences for investing in equity based on dividends is called the clientele effect.