Dividend payout policies for Gainesboro Tools Corporation
When a company makes a profit, it has the option of re-investing it or paying out dividends to shareholders and creditors. Black (1996) explained that when a company pays no dividends to its investors, the profits are invested back. In the financial year 2005 Gainesboro made profits and the management had the option of re-investing the whole amount, a portion of the profits and/or distribute dividends to shareholders and creditors. Unused debt capacity determines the borrowing capacity of an organization (Fosberg, 2008). Failing to pay dividends will reduce the unused debt capacity of Gainesboro since investors (shareholders and creditors) will not be compensated. It is a legal requirement that a company cannot borrow from investors if it has not compensated its existing shareholders and creditors (Myers, 2001).
According to Chandra (2008), residual dividend policy allows a company to spend portion of profits made in a financial period in projects and the remaining amount is distributed to shareholders as dividends. As such, Gainesboro will have a large amount of capital to finance its investment needs if a residual dividend policy is adopted. Unused debt capacity explains how much a firm can borrow from investors (Fosberg, 2008). Adopting a residual dividend payout by the management of Gainesboro Corporation will reduce the ability of the firm to borrow from investors. Investors include shareholders and creditors and since a residual dividend payout reduces the amount of returns paid to them, Gainesboro will have a reduced capacity to borrow.
It is important to note that Black (1996) was of the opinion that investors do not prefer holding stocks that do not pay dividends. He further explained that investors would consider holding stocks with lower prices but have dividend payout periodically. Adopting a zero dividend policy would affect investors of Gainesboro in that they would prefer selling out the stocks of the company and buying stocks of other companies which pay dividends. Since Gainesboro made a profit in 2005, the investors were expecting a dividend payout in that financial year. The management would risk negatively affecting the image of the company among its investors by adopting a zero dividend payout.
However, investors of Gainesboro holding very large stocks and operating in tax brackets that are restrictive would prefer a zero dividend payout. Black (1996) explained that investors are aware of tax consequences of any dividend payout policy and that “investors in high tax brackets seem to hold low-dividend stocks, and investors in low tax brackets seem to hold high-dividend stocks” (Black, 1996, pg. 11).
A zero dividend payout is important in that it protects shareholders and creditors operating in high tax brackets. Adopting this policy will improve the capital base and hence help venture into more business areas (Black, 1996). However, a zero dividend payout discourages investors since they do not gain from the capital invested in the company. It also reduces the ability of the company to borrow from the public since the unused debt capacity reduces when a zero dividend payout is adopted (1996).
Twenty percent dividend payout policy will be fair to both investors and the company. The shareholders and creditors obtain a small portion of the profits made by the company while the remaining amount (80%) is reimbursed into the capital structure of the company for further investment. The dividend payout policy of 20% will also improve the borrowing capacity (unused debt capacity) of the company since stockholders will be willing to buy stocks of the company.
Adopting a 40% dividend payout policy will attract more investors to the company. Since this is the highest dividend payout level, investors will be encouraged to buy stocks of the company since returns are high. This policy will increase the unused debt capacity by great margins. A 40 percent dividend payout would mean that shareholders and creditors obtain a huge benefit of the profits made by Gainesboro. To the company, adopting this policy will be disadvantageous since most of the profits are distributed to investors instead of re-investing the finances for development of the company. Chandra (2005) was of the opinion that a company should make some retention after every financial year to ensure there is progress in the development of structures and expansion of other capital intensive investments. Therefore, adopting a 40 percent dividend payout will reduce the capital base of the company and this will not be beneficial for long-term development of the company. However, the shareholders will benefit from such a policy.
Adopting a residual dividend payout will be beneficial to investors and the company. Investors will obtain a portion of the profits made by Gainesboro while the management gains expanding the capital base of the company. When a portion of the profits made by Gainesboro is distributed to investors while re-investing the remaining portions of profits, the company will be able to encourage its investors while maintaining growth and development. A residual dividend policy is therefore of great benefit since both the company and its investors gain from the profits made in a financial period (Brigham & Daves, 2010).
Ashley Swenson should recommend to the board of directors a residual dividend payout policy. This is in regard to a long-term dividend payout policy for Gainesboro Tools Corporation. Residual dividend payout policy has been found to benefit both the company and its investors. Adopting this policy will improve the capital structure by investing back profits made in any financial year (Chandra, 2005). The shareholders and creditors of Gainesboro will benefit from this policy since they will have returns for their stocks.
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