A focused business management team has a role of ensuring that the profitability of a business rises in future through undertaking various actions. I.e. expansions and product development by utilising the capital it has (Carnevale 2016). Profits that a firm makes could be dealt with in two major ways. The first is that the profit could be dispersed as a dividend to the shareholders of the firm. The other way is that the firm should agree to withhold the profit made and use the money to fund its expansion or any other project that could generate income for the firm. A higher proportion of the raised net profit could be voluntarily be reserved by the company (National Information Centre 2016). When part of profits are withheld and not dispersed as dividends, they are referred to as retained profits. This undistributed profits or reinvestment provides a business with a good source of finance. A dividend cut is a form of internal financing, and it is considered to be ownership funds as it belongs to the firm’s shareholders (Chad 2014).
There are several advantages and disadvantages of sacrificing dividends for reinvestment in the firm. Some of the advantages are as follows. As a source of finance, the retained profits are convenient and economical in that, the costs of advertising or for issuing any other prospectus is eliminated. Expenses and some legal formalities associated with some other finance sources are completely disregarded. Second, the company’s assets are not subjected to any charge or mortgage. Hence, the company in future can use its assets to raise loans if necessary. Third, the company is not obliged to repay this money; it doesn’t fix to repay this dividend to the shareholders in the future. This retained profit belongs to the company. Fourth, dilution of the firm’s control is not subjected to any risks as retained profits do not contribute to the addition of shareholders into the firm (Sontakke 2016). The management is subjected to no restrictions and therefore it remains independent.
Fifth, in terms of goodwill, the earning capacity, financial strength and credibility of the company are raised by retained profits. This makes a business eligible for being advanced with credits. Sixth, compared to external sources of finance, the dependability of using retained profit as an internal source of finance is higher. I.e. The preference of investors and market conditions does not influence the amount of funds. Regarding expansion and growth, retained profits are essential in facilitating business expansion and in the financing of new projects. New products innovation and development is also achievable through the use of retained earnings.
Since the amount of dividend this year is sufficient to fund the new product line, the company should acknowledge its shareholders of the new idea. The shareholders will agree with this idea since the new product line will earn more profits of which will add to their future dividends.
Every action that is advantageous has its limitations. Some of the limitations of cutting the dividend and using the funds for reinvestment are as follows. First, the rate of dividend this year will be greatly reduced. To be more specific it will be reduced to zero such that no dividend will be paid. Some shareholders may not be satisfied without receiving their usual expected dividend rate. Based on the fact that investors uses the dividend rate paid to gauge the profitability of a business, the cut will leave many questions to the investors and it might put away some of them. Second, the prices of a company’s shares may be speculated by its directors owing to the availability of huge reserves (Chad 2014). The directors in their favour may create a price change through changing of the dividend rate. Such share price fluctuations may cause the shareholders to make losses.
There is a risk that there may be a misuse of the funds by the directors for their personal benefits. The management assigns a low cost to retained profits and may invest the funds in non-profitable projects (Sontakke 2016). If the class of shareholders largely comprise of the retired, widows and those who are weaker economically, cutting of dividend may become difficult as they desire maximum dividend payment (Dhaval 2016).
The process of a dividend cut is only possible if the investors are well-off. It is, therefore, important for the management to consider the composition of its shareholders before making any cut decision. It should collect all the information on the proposed line of new products, do some cost and benefits analysis, and then present it as a business idea to the shareholders. If the investment opportunity proves to maximise their wealth in future, they will agree on the dividend cut for this period. Even if the action could keep away some investors, the previous stability on dividend rate would still help in maintaining the investors. Furthermore, the dividend cut is only for a single period, the investors will wait to observe the next period performance of which will be better. After the four years, more investors will be attracted to the business owing to the shooting of the dividend rate.
Carnevale, Chuck. "Dividends' True Contribution To Total Return May Surprise You". Yahoo Finance. 2016.
Chad, Smriti. "Retained Profits or Ploughing of Profits: It’s Advantage and Disadvantage". Yourarticlelibrary.Com: 2014. The Next Generation Library.
Dhaval, S. "Ploughing Back Of Profits| Financial Management". Business Management Ideas. 2016.
National Information Centre,. "Business Portal of India: Growing a Business: Financial Support: Ploughing Back Of Profits". Archive.India.Gov.In. 2016. Accessed July 9.
Prasad, Kumar. "Dynamic Tutorials and Services: Retained Earnings or Ploughing Back of Profits: Meaning, Need, Advantages, Limitations and Factors Affecting It". Dynamictutorial.Blogspot.Co.Ke. 2015.
Sontakke, Kaustubh A. "Sources of Finance". Drsontakke.Com. 2016.