Factors Affecting Corporate Dividend Policy Decisions
Factors that affect a company’s dividend policy decision include:
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 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.
- CFA Level 2: Corporate Finance Part 1 – Introduction
- Introduction to Capital Structure and Leverage
- Introductory Capital Budgeting Remarks
- Expansion Projects vs. Replacement Projects and Cash Flows
- Impacts of Depreciation Method Choice on Capital Budget Analysis
- Inflation and Capital Budgeting
- Mutually Exclusive Capital Projects with Unequal Lives
- Equivalent Annual Annuity (EAA) Approach
- Least Common Multiple of Lives Approach
- Stand Alone Risk and Capital Projects
- CAPM and a Capital Project’s Discount Rate
- Capital Projects and Real Options
- Common Pitfalls in Capital Budgeting
- Capital Budgeting Alternatives to NPV and IRR Analysis
- Modigliani-Miller and Capital Structure Theory
- Evaluating Capital Structure Policy
- International Differences in Financial Leverage
- Dividend and Share Repurchase Policies
- Factors Affecting Corporate Dividend Policy Decisions
- Signals from Dividend Policies