This lesson examines the various dividend policies that firms may adopt in practice, ranging from stable dividend policies to residual policies, and the factors that influence the choice between different strategies .

• Stable Dividend Policy: Under this policy, a company tries to align its dividend growth rate to the company’s long-term earnings growth rate. Dividends may increase even in years when earnings decline, and dividends will increase at a lower rate than earnings in boom years .

  • Constant Dividend Per Share: A fixed amount per share is paid irrespective of earnings fluctuations.

  • Low Regular Dividend Plus Extra: A minimum dividend is paid each year with the option of declaring extra dividends in prosperous years.

• The Gradual Adjustment Model (Lintner): A stable dividend policy can be represented by a gradual adjustment process in which the expected dividend is equal to last year’s dividend per share plus [(Expected earnings × Target payout ratio − Previous dividend) × Adjustment factor] . This model explains why dividends change with earnings but with a lag.

• Constant Dividend Payout Ratio Policy: Under this policy, a company applies a target dividend payout ratio to current earnings. Therefore, dividends are more volatile than with a stable dividend policy .

• Residual Dividend Policy: Under this policy, dividends are paid only from earnings not needed to finance new acceptable capital projects. The dividends will fluctuate depending on investment opportunities available. This approach is theoretically optimal under the MM irrelevance framework.

• Factors Influencing the Choice of Dividend Policy: Several factors determine which policy a firm adopts:

  • Investment Opportunities: Companies with profitable investment opportunities typically have lower payout ratios .

  • Earnings Volatility: The volatility expected in future earnings affects dividend stability .

  • Financial Flexibility: The need to maintain financial flexibility influences payout decisions .

  • Tax Considerations: The tax treatment of dividends and capital gains .

  • Flotation Costs: Costs of issuing new securities .

  • Contractual and Legal Restrictions: Debt covenants and legal statutes .

• Dividend Policy in an International Context: Conventional wisdom states that German dividends are lower than UK or US dividends, yet on a published-profits basis the exact converse is true . This highlights the importance of understanding accounting differences when comparing dividend policies across countries.