One of the methods of maximizing share holder wealth

As we all know, the main objective of the existence of any business is maximizing the wealth of the share holders. For a listed company there are mainly two main methods,

1. Capital gains - The gain due to the increase in share price

2. Dividends - explained

Dividends decision is very important for any company because it is a realized gains for share holders in compared with capital gains after selling the shares, there are mainly four main policies which could be identified,

a) Constant dividend policy - There is no rocket science, as the name implies it is a dividend policy where a company decides to pay a constant amount each year, for instance 50 cents for $10 share.

Pros - This would quite attracting for pensioners who can be reliant on a constant return for the investment.

Cons - Even if the company is achieving sky rocketing profit levels, still the share holders would not be able to gain from the increased profits. And also it is a fact that we cannot buy what we buy for 50 cents in a years time hence this policy does not consider time value for money.

b) Constant growth in dividends - The dividend amount increases yearly at a constant percentage. ex: The company would increase the dividend by 5% each year.

In three years time = 50 cents* 1.05*1.05*1.05 = 58 cents

This method mainly focuses on giving a time value for money. Yet in an instant where the companies making high profits, this does not increase the profits.

c) Constant pay out ratio - Under this method there is a constant ratio that will be distributed. For example if the pay out ratio is 40%, then an instance where the company makes a profit of $1 million, the share holders would be awarded with 0.4m. Under this method when the company is earning high profits the dividend would also increase proportionately. But when the company does not make any profit neither the share holder will earn any dividend

d) Residual dividend policy - This policy is the most famous amongst companies. This is where a company keeps the amount needed for future investments and distribute the rest to its share holders. It is very simple even in our life, when we get our salary we keep the amount that we would need for the months expenditure, and we save the rest in a savings account or invest.

A company has to make the most suitable dividend policy with intention of maximizing share holder wealth.