Question

It took eight years before Microsoft Corporation could declare its first dividend. Some
companies declare dividends within one year or two years of commencing operations.
Firms have different dividend policies. During your company’s board meeting last week,
the directors argued on whether the company should declare a dividend or not. The
centre of the argument was on whether declaring or not declaring a dividend had effect
on the value of the firm.
a. Explain the three main types of dividend policies that may be adopted by firms.

b. State any three factors firms consider in arriving at a dividend policy?

c. Discuss the theory of dividends with specific reference to the Dividend Irrelevant
Theory and Dividend Relevant Theory.

Answer 1

Answer a - Types of dividend policy:

• Stable dividend policy - This policy ensures steady and stable dividend payout each year to its investors, irrespective of company earnings.
• Constant dividend policy - This policy pays a percentage of its earnings as a dividend each year so that during boom years of the company, the investors can receive higher payouts.
• Residual dividend policy - This policy pays a dividend to investors from what remains after the company has paid out its expenses

Answer b - Factors firms consider from dividend payout:

• Liquidity status
• Stability of earnings
• Financial needs of the firm

Answer c -

Dividend policy- Dividend policy enables firms to plan out its dividend payout to its investors

Dividend irrelevant theory: Under this policy, investors do not worry about the company's dividend policy as they don't have the option to sell a portion of equities from their portfolio if they want to cash out.

Dividend relevant theory: Here the dividend payout ratio will be altered based upon the market performance of the firm