Dividend decision

Distributing Profits vs. Reinvesting in the Business

Dividends represent a portion of a company's net earnings that are paid out to its shareholders. This section focuses on dividends paid to ordinary shareholders in widely-held public companies.

Core Concepts

• Dividends: Cash payments made to shareholders, representing a share of the company's profits.
• Retained Earnings: The portion of net earnings that a company keeps for reinvestment in the business.
• Inverse Relationship: There's an inverse relationship between dividends and retained earnings: the more a company pays out in dividends, the less it retains for reinvestment, and vice-versa.

The Dividend Decision: A Fundamental Choice

A major financial management decision is the dividend decision. This means that the firm has to pick between handing out the profits to stakeholders, or ploughing the profits back into the business. This decision often hinges on the effect of the decision on the maximization of shareholders’ wealth. The dividend decision involves balancing these conflicting goals:

• Distributing profits to shareholders (dividends).
• Reinvesting profits back into the business (retained earnings).

The main goal is to follow an approach that maximizes shareholders wealth. To achieve this, the firm will have to take the following issues into consideration:

• The relationship between dividends and value of the firm should, therefore, be the decision criterion.
• The firm must consider as to which alternative use is consistent with the goal of wealth maximization.
• The firm would be well advised to use the net profits for paying dividends to the shareholders if the payment will lead to the maximisation of wealth of the owners.
• If not, the firm should rather retain them to finance investment pro-grammes.

Conflicting Opinions: Do Dividends Matter?

There are two main schools of thought regarding the impact of dividends on firm valuation:

1. Dividend Irrelevance: Some argue that dividends are irrelevant and don't affect the value of the company.
2. Dividend Relevance: Others believe that dividend policy significantly influences the value of a firm, measured by its share price.