Answer to Question #223936 in Economics for Andrick Angel

Question

Why is the dividend decision one of the major areas that a finance

manager should pay particular attention to? What considerations must

be taken into account when setting a dividend policy of a company? (12

marks)

A company’s sources of long-term funds include bonds, preferred

stock and common stock. Identify some financing risks associated with

these sources and explain how these risks affect the return expected

from investments financed by these sources. (13 marks)

Answer 1

Dividend policy is one of the most important financial decisions that a Financial Manager must make is related to the company's dividend policy. It is necessary to determine if generated earnings will be reinvested in the company to improve operations or if they will be distributed among shareholders.

The following are some of the important factors, which influence dividend policy of a concern:

• Stability of Earnings,
• Financial Policy of the Company,
• Liquidity of Funds,
• Ability to Borrow,
• Growth Needs of the Company,
• Profit Rate,
• Legal Requirements,
• Policy of Control.

Both bonds and preferred stocks are sensitive to interest rates, rising when they fall and vice versa. If a company declares bankruptcy and must shut down, bondholders are paid back first, ahead of preferred shareholders.

Owners of common stock have no guarantees, but are accepting the risk in exchange for potential greater gains than other safer investments. However, the shareholder's liability is limited to the price paid for the common stock. Common stock can be very volatile and is generally considered a high risk investment class.