Dividend policy refers to a set of guidelines that business firms always use when deciding on a number of its periodic earnings it will pay to the shareholders which are usually determined by the business firm's long-term earning power and cash flow.
Limitations of the dividend policy are theoretically discussed using two theories that explain restrictions about the dividend policy. These theories are the residuals theory of dividend and the Modigliani and Miller theory.
This theory state that if a business company has an excellent investment opportunity available, then the management will invest the retain earnings and reduce the rate of dividend offered to the shareholders, and in the absence of investment opportunity then the business firm will pay out dividend using its expenses depending on the company's profit. The dividend to be paid is usually affected by the profit, and in most cases, the management can reduce the amount of dividend payout so that it can retain its advantage thus the amount of equity finance is always evaluated to determine the required investment.
This theory is all about division of the retained earnings between the new investment and the dividends usually have no impact on the value of the business company. The share price is thus often affected by the investment pattern and the company's earnings. The dividend is therefore affected by the behavior of investors, and there are usually no taxes or floatation cost hence the amount of money used to pay out dividends is paid back through capital obtained from issuing of shares.
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