For any business entity, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows:
a) The management of many business entities believes that retained earnings are funds which do not cost anything, although this is not .However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash.
b) The dividend policy of the business entity is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders.
c) The use of retained earnings as opposed to new shares or debentures avoids issuing costs e.g. floatation costs, advertising.
d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares. This may lead to dilution of ownership.
Another factor that may be of importance is the financial and taxation position of the business entity's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, and then finance through retained earnings would be preferred to other methods.
A business entity must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a business entity that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.
Retained earnings can be insufficient to finance all the projects a business entity wants to undertake and so if a business entity only depends on retained earnings it may end up undertaking few projects.
Lellah answered the question on November 8, 2021 at 07:18
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