The Finance Manager has to decide the dividend policy very carefully. A wrong dividend policy may put the company into financial troubles and the capital structure of the company may get unbalanced.

The growth of the company may get hampered if sufficient resources are not available to implement growth programs.

The Finance Manager has to formulate the dividend policy in such a way, which coincides with the ultimate object of the finance function of maximizing the wealth of shareholders and value of the firm.

Importance of Dividend Policy

Profits earned by a company may be handled by it basically in two ways:

1.    To distribute the profits among the shareholders by way of dividend.
2.    To retain the profits in the business to be used in future.

There are no strict rules and guidelines available to decide as to what portion of the profits should be distributed by way of dividend and what portion should be retained in the business. As such, to decide the dividend policy may be one of the most trickiest and delicate decisions which the management of the company may be required to take.

If the management decides to retain a large portion of the profits in the business, funds required for future expansion and modernization needs of the company may be available to it on long-term basis, without any obligations to repay the same. The expansion or modernization programs may improve the earning capacity of the company in future, which may carry forward the growth of the company.

The company may be able to absorb the shocks of business fluctuations and adverse situations boldly. A strong and stable company may earn the confidence of the investors and creditors and funds may be available to it at reasonable rates conveniently.

As a result, the share prices and the value of the company will increase. Thus, though the shareholders are required to fore go the dividends in the short run, they get benefit in the long run.

On the other hand, if the management decides to distribute a large portion of profits by way of dividend, the company may be able to earn the confidence of the shareholders and may be able to attract the prospective investors to invest in the securities of the company.

Shareholders are necessarily interested in getting larger dividends immediately due to the time value of money and due to uncertainty regarding the future. Shareholders are thus attracted to the companies paying high dividends, due to which prices of the shares and value of the company increases.

Thus it can be seen, that both high retentions and high dividends may be desirable, but there is necessarily a reciprocal relationship between the retentions and dividends. The skill of the Finance Manager lies in striking the balance between these two extremes.