1. What should be the average pay ratio?
   
2. How stable should the dividends be over time?
   

Firms consider the following factors to determine the payout ratio –

1. Funds requirement – The dividend pay out ratio of firms depends on the firm’s future requirements for funds. Long term financial forecasting of funds can assess this requirement. Usually firms, which have plans for substantial financial investment, need funds to exploit the available opportunities. Thus, they keep their dividend payout ratio low. On the other hand, firms, which have very few investment avenues have larger dividend pay out ratio.
   
2. Liquidity – It is another factor which influences the dividend payout ratio as dividends involved cash payment. Firms, which desire to pay dividends may not do so, because of insufficient liquidity. This usually happens in the case of profitable and expanding firms, which have very low liquidity because of substantial investments.
   
3. Availability of external sources of financing – Firms which have easy access to external sources of funds enjoy a great deal of flexibility in deciding the dividend payout ratio. For such firms, dividend payout decision is somewhat independent of its investment decision as well as its liquidity position. Such firms are usually more generous in their dividend policies. While on the other hand, firms, which do not have easy access to external sources of funds, have to rely on the internal sources of funds or investment purposes. Such firms are usually very conservative in their dividend policy decisions.
   
4. Shareholder preference – Preferences of shareholder are onother major factor, which influence dividend payout. If shareholders prefer current income to capital gains, then the firm may follow the liberal dividend policy. While on the other hand if they prefer capital gain to dividend income, then firms follow the conservative dividend policy.
   
5. Difference in the cost of external equity and retained earnings – The cost of equity in all cases except for those raised by way of rights issue is higher than the cost of retained earnings. Depending on the extent of this difference in cost, firms decide the relative proportion of external equity and retained earnings to be used. This affects the dividend policy decision of the company.
   
6. Control – Raising money from external resources may lead to dilution of control, in case money is raised by issuing public equity. Internal financing on the other hand does not lead to any dilution of control. Hence, if management and shareholders are averse to dilution of control, then firms prefer to rely more on retained earnings. Thus, such companies may adopt, the conservative dividend policy.
   
7. Taxes – In India dividend income for the individuals is free, however capital gains are taxable. Thus, in that case shareholders who are in high tax bracket may prefer dividend income rather than capital gains. However, if tax on dividends is viewed from point of view of corporates, they have to pay dividend tax. Thus, this may influence the companies’ dividend policy.