Policy involves the decision to pay out earnings to shareholders or to retain and reinvest them in the firm. when distributing income to stockholders there are three key issues to consider: (1) how much should be distributed? (2) should the distribution be in the form of dividends, or should the cash be passed on to shareholders by stock?
(3) how stable should the distribution be? when deciding how much cash to distribute, a firm's managers must remember that the firm's objective is shareholder value. the ratio is defined as the percentage of net income distributed as cash dividends, and it should be based on investors' preferences for dividends versus capital gains. any change in this ratio will have two opposing effects: (1) if dividends are increased, then taken alone this will cause the firm's stock price . (2) however, an increase in dividends will also cause the firm's expected growth rate and this will tend to firm's stock price. the policy is the one that strikes a balance between current dividends and future growth the firm's stock price.