How does the dividend decision of a company influence its financing decision?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → Re-invested retained earnings reduce the funds the firm needs to raise from other sources.
Option (1) Re-invested retained earnings reduce the funds the firm needs to raise from other sources. — Correct. Profit kept back is put back into the business. The firm does not need to raise funds to the extent of re-invested retained earnings. So the dividend decision sets how much must come from other sources.
Option (2) Lenders may restrict future dividend payments through the terms of their loan agreements. — Incorrect. This is the contractual constraint. Here the loan terms limit the dividend, so a financing source affects the dividend decision, the reverse direction.
Option (3) A higher dividend adds to the floatation costs, so a public issue of shares becomes less attractive. — Incorrect. Floatation cost is the cost of raising funds, such as the expense of a public issue of shares. The dividend paid does not add to it.
Option (4) A higher dividend makes debt relatively cheaper, so it increases the attraction of debt over equity. — Incorrect. Debt becomes relatively cheaper when the tax rate is higher, because interest is a deductible expense. The dividend paid does not change the cost of debt.
NCERT (2026-27 Edition): “Dividend Decision The third important decision that every financial manager has to take relates to the distribution of dividend. Dividend is that portion of profit which is distributed to shareholders. The decision involved here is how much of the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business. While the dividend constitutes the current income re-investment as retained earning increases the firm’s future earning capacity. The extent of retained earnings also influences the financing decision of the firm. Since the firm does not require funds to the extent of re-invested retained earnings, the decision regarding dividend should be taken keeping in view the overall objective of maximising shareholder’s wealth.” “(k) Contractual Constraints: While granting loans to a company, sometimes the lender may impose certain restrictions on the payment of dividends in future. The companies are required to ensure that the dividend does not violate the terms of the loan agreement in this regard.” |