Costs Associated with Dividend Policy. Capital floatation costs are a deterrent substituting external finance for retained earnings but there are other costs affected by the dividend decision.
If shareholders are left to make their own dividends by selling some shares, this involves brokerage and other selling costs that, on a small number of shares, can be extremely an economic.
In addition, if they have to be sold during a period of low share price, capital losses may be suffered. Another important factor is taxation. First, when the company distributes dividend it has to pay an advance installment of corporation tax ACT, currently one quarter of the amount paid. But the offset against mainstream liability to pay corporation tax will be delayed by at least one year. Indeed, if the company does not currently pay this type of tax, the delay in setting off ACT will be even longer, and this will tend to restrain extravagant dividend distributions.
Second, from the investors viewpoint profitability invested retained earnings should increase share values, enabling shareholders to create their own dividends. Selling shares creates a liability to capital gains tax, currently 20, 23 or 40, but subject to a fairly generous exemption limit. By comparison, dividends in the hands of shareholders attract higher rate of income tax up to 40. Thus higher-rate taxpayers may prefer comparatively low dividend payouts to minimize their tax burden.
Third, financial institutions confuse the taxation picture even more, through their major holdings in the shares of quoted companies. They are able to set off dividends received against dividends paid for tax purpose but some may be liable to capital gains tax if they sell shares to make dividends. The effect of taxation on dividend decision is difficult to analyse.
It may be argued that companies attract investors who can match their personal taxation regimes to company s dividend policy, and that those who don t join a particular taxation club will invest elsewhere. If this were true, however, a change in company s dividend policy would probably not find favour with its shareholders clientele. And would consequently affect share values, which seem to support the argument that dividend policy matters. 3.