Legally directors have considerable liberty to use their discretion’ to dispose of the earnings of the company. But shareholders are the legal owners of the company, and directors, appointed by them, are their representatives. Therefore, directors should give due importance to the expectations of shareholders in the matter of dividend decision. Shareholders’ preference for dividends or capital gains depends on their economic status and the effect of tax differential on dividends and capital gains. A wealthy shareholder in a high income-tax bracket may be interested in capital gains as against current dividends. On the other hand, a retired person with small means, whose main source of income is dividend, would like to get regular dividend and may not be interested in capital gains.
Closely-held Companies
In case of a closely held company, management usually knows the expectations of share-holders. Therefore, they can easily adopt a dividend policy, which satisfies all shareholders. The body of the shareholders is a small, homogeneous group in a closely-held company. If most of the shareholders are in high tax brackets and have a preference for capital gains to current dividend incomes, the company can establish a dividend policy of paying less or no dividends and retaining the earnings within the company.
Widely-held Company
It is a formidable task to ascertain the preferences of shareholders in a wide-held company. The number of shareholders is very large and they may have diverse desire regarding dividends and capital gains. As a result, it is not possible in case of widely held company to follow a dividend policy, which equally satisfies all shareholders. The firm can follow a dividend policy, which serves the purpose of the dominating group, but does not completely neglect the desires of others. Shareholders of a widely held company may be divided, for example, into four groups: small, retired, wealthy and institutional shareholders?
Small Shareholders
Small shareholders are not the frequent purchasers of the shares. They hold a small number of shares in a few companies. They generally purchase or sell shares on the advice of stockbrokers or friends. Their purpose sometimes is to receive dividend income, and sometimes, if possible, they may like to make capital gains. Thus, the small shareholders do not have a definite investment policy. They purchase shares only when their savings permit. This group rarely proves to be dominating in the body of shareholders in a company and it is not much concerned with the dividend policy of the company.
Retired and Old Persons
Retired and old persons generally invest in shares to get a regular income. They use their savings or pension funds to purchase shares. Therefore, these persons may select shares of the companies which’ have a history of paying regular and liberal dividends. However, a retired person who has some source of income and is in a high tax bracket may be interested in capital gains.
Wealthy investors
Wealthy investors are very much concerned with the dividend policy followed by a company. They have a definite investment policy of increasing their wealth and minimizing taxes. These persons are in high tax brackets and the dividends received in cash by them would be taxed at a high rate. Therefore, they generally prefer a dividend policy of retaining earnings and distributing bonus shares. The wealthy shareholders’ group is quite dominating in many companies as they hold relatively large blocks of shares and are able to influence the composition of the board of directors by their majority voting rights. On the dividend policies of these companies, this group will have a considerable influence.
Institutional Investors
Institutional investors purchase large blocks of shares to hold them for relatively long periods of time. Institutional investors, unlike wealthy shareholders, are not concerned with personal income taxes but with profitable investments. Most institutional investors avoid speculative issues, seek diversification in their investment portfolio and favour a policy of regular cash dividend payments.
It should be obvious from the above discussion that, in the case of a widely-held company, the interest of the various shareholders’ groups are in conflict, it is not easy to reconcile these conflicting interests of the different types of shareholders. However, directors should consider following two points:
First, directors should adopt such a dividend policy, which gives some consideration to the interests of each of the groups comprising a substantial proportion of shareholders.
Second, the dividend policy, once established, should be continued as long as it does not interfere with the financing needs of the company.
A definite dividend policy, followed for a long period in the past, tends to create the clientele effect. That is, it attracts those investors who consider the dividend policy in accord with their investment requirements. If the company suddenly changes its dividend policy, it may work to the detriment of these share-holders, as they may have to switch to other companies to fulfill their investment needs. Thus, an established dividend policy should be changed only after having analyzed its probable effects on the existing share-holders. It should be changed slowly and not abruptly.
