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Dividend policy is the decision making process concerned with paying cash dividends to shareholders. Usually when a company has excess cash the management is expected to distribute the surplus cash in the form of cash dividends. Alternatively, the company can also decide to repurchase its stock through a share buyback program. A company may choose to pay its due dividends in the present or paying an increased dividend at a later stage. Companies may also opt to pay stock dividends to its shareholders rather than cash dividends which would lead to higher capital gains but at the expense of restricted liquidity. Since the valuation of a company’s shares depends greatly on the dividend expectations of its shareholders hence a company’s dividend policy has a significant bearing on its financial situation. Finance theory states that management should return some or all of the excess cash to shareholders as dividends in the event that returns are higher than the hurdle rate and excess cash is not required. While this is the general theory functional in most circumstances, in the case of “growth stock”, the growth of the company is prioritized and so the majority of the dividend is retained by the management for use in developing the company. This is done with the view that development of the company and its operations would eventually lead to proportionately higher dividends in the future.
Some financial theories have supported the paying of financial dividends from excess cash while others have proposed that dividend payout whether it is in the form of cash or stock. Financial theories which support dividend policies are Walter’s Model, Gordon’s Model, Capital structure substitution theory and dividends. Financial theories which reject the relevance of dividend policy are Residual theory on Dividends, Modiliani-Miller Theorem.
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