Dividend Policy: Meaning, Definition, Objectives, Types, Theories and Factors

Dividend refers to that portion of profit (after-tax) which is distributed among the owners or shareholders of the firm. The finance manager has to take few decisions which are inter-related like investment, financing and dividend decisions. Dividend decision is related to the shareholders’ expectation from the shareholder’s share in the profits of the company.

The focus of the dividend decision is on the dividend paid to the equity shareholders, as preference shareholders are entitled to a fixed rate of dividend.

Dividend policy determines the amount of earnings to be distributed amongst the shareholders and the amount of earnings to be retained. Retained earnings are that portion of earnings which is to be ploughed back in the firm as reinvestment.

Dividend Policy refers to the policy chalked out by firms regarding the amount they would pay to their shareholders as dividend. Once firms make profits, they have to decide on what to do with these profits.

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Dividend policy of a company is the strategy followed to decide the amount of dividends and the timing of the payments. There are various factors that frame a dividend policy of the company.

According to Weston and Brigham, “Dividend policy determines the division of earnings between payments to shareholders and retained earnings”.

Contents

Dividend Policy – An Overview
Introduction to Dividend Policy
Meaning of Dividend
Definition of Dividend
Meaning of Dividend Policy
Definition of Dividend Policy
Objectives of Dividend Policy
Factors to be Considered While Framing Dividend Policy in an Organization
Types of Dividends Offered to The Shareholders
Significance of Dividend Policy
Importance of Dividend Decision
Forms of Dividend in a Company
Alternate Forms of Dividend
Informational Contents of the Dividend
Theories of Dividend Policies
Modigliani-Miller’s Model (M-M’s Model)
Factors Affecting the Dividend Division of a Firm
Approaches to Dividend Policy
Approaches to Dividend Decisions
Dividend Payout Ratio
Right Issue of Shares
Cash Dividend
Stock Dividends
Bonus Shares
Formulating Optimal Dividend Policy
Benefits of Dividend Payment in a Company
Stability of Dividend
Stable Dividend Policy
Importance of Stable Dividend Policy in Companies
Corporate Dividend Practice in India
Informational Contents of the Dividend
Interdependence of Dividend, Investment and Financing Decisions
Payment of Dividends and Dividend Distribution Procedure
Difference between Cash Dividend and Stock Dividend
Considerations
Multiple Choice Questions and Answers

What is a Dividend Policy: Meaning, Definition, Objectives, Types, Significance, Forms, Theories, Factors, Approaches, Stable Dividend Policy and More…

Dividend Policy – An Overview

A question arises before the management of a company that what should be its dividend policy and what should be the considerations before the dividend is declared? One thing is sure that the shareholders have a preference for cash dividend and it is necessary to meet their expectations. They are not satisfied by a promise of capital gains because ‘a bird in hand is better than two in the bush’. Secondly, dividend is an important signaling device.

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Since, most of the shareholders, do not understand accounting concepts like book-value per-share, return on equity, earnings per share etc., they tend to measure a company’s performance in terms of dividend distributed by it. A company giving high dividend is perceived to be performing well and a none or low dividend paying company is perceived to be a non-performer.

A company which is consistently increasing its dividend payment is considered to be a growing company and vice versa. Under this situation, it is essential for a company to pay some dividend to its shareholders. The only consideration before them is to decide how much dividend should be paid for the given year?

In its decision to pay dividend to its shareholders, a company should, therefore, consider the following points:

(i) The first thing is to consider the relationship between r and k. If r > k, low dividend should be recommended and vice versa if r < k.

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(ii) The second point to consider in deciding the dividend payout is to look at funds availability. Dividend payment entails an immediate payment of cash and if the funds position is tight, then it is not advisable to give a high dividend.

Similarly, if huge idle funds are available anytime during a year, a company’s management may consider payment of an interim dividend based on its assessment of profit for the year. This relieves the pressure on the company to pay a dividend after the accounting year is over.

(iii) Another consideration before a company is to look at the availability of funds from outside. If funds from outside are not available, then the company has to entirely depend on its internal accruals to meet the requirement of funds.

In such a situation, payment of dividend may be avoided to conserve its financial resources. If, on the other hand, a company can have easy recourse to funds from outside, it may be liberal in giving dividends because any requirement of funds can be easily met by borrowings.

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(iv) Taxation of dividends is also a consideration in deciding the dividend policy. In many countries dividends are taxed in the hands of shareholders. This reduces after tax returns to them. In such a situation, companies may give returns to the shareholders in the form of bonus shares or share buyback. Both these methods give a ‘capital gain.’ in the hands of shareholders, which are taxed at a lower rate rather than the incomes which entail a higher tax rate.

In India, under the present tax laws, dividends are tax free in the hands of shareholders but the company is required to pay a ‘dividend distribution tax’ (DDT), which creates a wedge between burden to the company and the return to the shareholders. This DDT is a disincentive to a company to pay a high dividend to the shareholders.

(v) Before declaring a dividend, a company’s management has to consider whether they will be able to maintain the dividend in future also. If a high dividend is followed by a low dividend in future, it is considered a poor reflection on the working of a company and that has an adverse impact on the market price of the share. It is, therefore, considered better to be conservative i.e. give a low but continuously growing dividend to the shareholders.

(vi) It is also necessary to look at the preference of the shareholders. Do the shareholders prefer cash dividend or do they prefer capital gains. If they prefer cash dividends then the management should adopt a high dividend policy and if they prefer capital gains then it is better to follow a low dividend policy.

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Age profile of the shareholders also has an impact on the preference of the shareholders. If the majority of shareholders are young, they would have a natural preference for growth rather than immediate cash dividend. If they are old, they would have a natural preference for cash dividend rather than growth in future. The dividend policy of a company should take into consideration this factor also.

(vii) There are certain statutory rules and regulations which the governments make with regard to transfer of a portion of profits to statutory and other reserves and for paying dividends. Similarly, the governments often have MOUs with some statutory entities and government corporations. It is necessary to adhere to these regulations, in making dividend decisions.

Dividend Policy – Introduction

The focus of the dividend decision is on the dividend paid to the equity shareholders, as preference shareholders are entitled to a fixed rate of dividend.

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Dividend is important to equity shareholders as it increases their current income. Thus, the crucial issue of financial management is how the earnings of the firm should be divided between retention in the firm and payment to the owners.

Dividends are distributed out of the profits earned by the company. Cash inflows generated by the business are used for payment of dividend to its equity shareholders. Dividend payment is a cash outflow. Dividends are periodic cash payments by the company to its shareholders.

Dividend payment to the equity shareholders are made after making fixed financial payments like interest on debt and dividend on preference shares. To distribute the dividends, company must earn profits.

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Alternative to the distribution of dividend is retained earnings or retention of profits. The choice between payment of dividend and retained earning depends on the effect of this decision on the maximisation of shareholder’s wealth. If the decision to pay the dividend maximises the wealth of the owners then the firm should pay the dividend to its shareholders.

If dividend payment does not maximise the wealth of the owners then firms should retain the earnings and invest these funds in the projects where maximum returns can be gained. A company can declare the dividend in its general body meeting as per the rate recommended by the Board of Directors.

Further the dividend can be interim or final. Board of Directors can pay interim dividend before finalisation of accounts, if they expect sufficient profit in a particular year. Dividends can also be paid in the form of stock i.e. bonus shares.

Dividend Policy – Meaning of Dividend

The term dividend refers to that part of the profit (after tax) which is distributed among the owners/ shareholders of the firm. In other words, it is a taxable payment declared by a firm’s board of directors and given to its shareholders out of the firm’s current or retained earnings, usually quarterly.

Dividends are usually given as cash (cash dividend), but they can also take the form of stock (stock dividend) or other property. Dividends provide an incentive to own stock in stable firms even if they are not experiencing much growth. Firms are not required to pay dividends.

The firms that offer dividends are most often firms that have progressed beyond the growth phase and no longer benefit sufficiently by reinvesting their profits. So they usually choose to pay them out to their shareholders, also called payout.

Dividend Policy – Definition of Dividend

Dividend may be defined as “Divisible profit distributed amongst the members of a company, in proportion to their share in such a manner as is prescribed by the memorandum and Articles of Association of the company”.

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A very brief definition is “a dividend is a share of the profits of a company dividend amongst the shareholder”.

Dividend Policy – Meaning

The firms have two options with them:

a. They can retain these profits within the firm.

b. They can pay these profits in the form of dividends to their shareholders.

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The dividend policy to be adopted by the firm is based on these two options. If the firm pays dividends, it affects the cash flow position of the firm but earns goodwill among the investors who, therefore, may be willing to provide additional funds for the financing of investment plans of the firm.

On the other hand, the profits which are not distributed as dividends become an easily available source of funds at no explicit costs. However, in the case of ploughing back of profits, the firm may lose the goodwill and confidence of the investors and may also defy the standards set by other firms.

Therefore, in taking the dividend policy, the finance manager has to strike a balance between distribution and retention. He should allocate the earnings between dividends and retained earnings in such a way that the value of the firm (i.e., wealth of shareholders) is maximised.

Dividend Policy – Definitions

Dividend policy of a company is the strategy followed to decide the amount of dividends and the timing of the payments. There are various factors that frame a dividend policy of the company.

Availability of better investment opportunities, estimated volatility of future earnings, tax considerations, financial flexibility, flotation costs and various other legal restrictions affect a company’s dividend policy.

The term dividend policy has been defined by some authors as given below:

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(i) Weston and Brigham: Dividend policy determines the division of earnings between payments to shareholders and retained earnings.

(ii) Gitman: The firm’s dividend policy represents a plan of action to be followed whenever the dividend decision must be made.

Definition:

According to Weston and Brigham, “Dividend policy determines the division of earnings between payments to shareholders and retained earnings”.

While determining the dividend policy, the dividend declared during previous years may be taken as a base and the same rate is followed in the coming years. Generally the Board of Directors aims at maintaining the dividend rate, which we may call a stable Dividend Policy.

For this purpose a dividend equalisation fund is created out of profits, to equalise the profits of the coming years.

Top 4 Objectives of Dividend Policy

The main objective of financial management is to maximize the value (wealth) of the company. The market value of equity shares of a company is greatly affected by its policy regarding allocation of net profit/surplus between pay-out (dividend) and plough-back (retained earnings).

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“Whether to distribute dividend or not” is not the alternative available to management. Of course, the real question is as to how much to distribute as dividend Answer to this question lies in the dividend policy.

While chalking out dividend policy the following points of objectives must be considered:

(i) Whether the payment of dividend should be made from the initial years of operations (i.e., should there be regular dividend).

(ii) Whether a fixed amount of dividend or fixed percentage of dividend should be given irrespective of the amount (volume) of profit earned (i.e., should there be constant dividend).

(iii) Whether a definite percentage of profit should be given as dividend which means variable dividend per share (i.e., a definite pay-out ratio should be there).

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(iv) Whether the dividends be paid in cash or in other forms.

Factors to be Considered While Framing Dividend Policy in an Organization – Fund Requirements, Expectations of Shareholders and Status quo Factor

Before framing dividend policy, the organization should take into consideration the following factors:

Factor # 1. Fund Requirements:

Refer to the availability of funds with the organization so that it can distribute dividends. If the organization does not have sufficient funds then it cannot distribute dividends.

Factor # 2. Expectations of Shareholders:

Influence the decision of the board of directors to distribute dividends. If the organization generates more profit, then the expectations of the shareholders increase and they demand a high dividend.

Generally, the shareholders prefer to receive a regular amount of dividend. Therefore, the organization should take into consideration the expectations of shareholders while determining the dividend policy.

Factor # 3. Status quo Factor:

Refers to different factors, which the organization needs to consider while determining dividend policy. There is no strict law regarding the formulation of dividend policy. However, in general, rate of dividend increases with the increase in profit and decreases with the decrease in profit.

According to professor I. M. Pandey, organizations should know the answers of following questions before formulating dividend policy:

i. What are the preferences of shareholders: dividend income or capital gain?

ii. What are the financial needs of the company?

iii. What are the constraints on paying dividends?

iv. Should the company follow a stable dividend policy?

v. What should be the form of dividend (i.e., cash or bonus shares)?

Dividend Policy – Types of Dividends Offered to The Shareholders: Regular, Interim, Stock, Bond and Property Dividend

Following are the different types of dividends offered to the shareholders of the firm:

Type # (i) Regular Dividend:

It is paid annually, proposed by the board of directors and approved by the shareholders in general meeting. It is also known as final dividend because it is usually paid after the finalisation of accounts.

It is generally paid in cash as a percentage of paid up capital, say 10% or 15% of the capital. Sometimes it is paid per share. No dividend is paid on calls-in-advance or calls-in-arrear.

Type # (ii) Interim Dividend:

If Articles permit, the directors may decide to pay a dividend at any time between the two Annual General Meetings before finalising the accounts. It is generally declared and paid when the firm has earned heavy profits or abnormal profits during the year and directors wish to pay the profits to shareholders. Such payment of dividend in between the two Annual General meetings before finalisation of accounts is called Interim Dividend.

No interim dividend can be declared or paid unless depreciation for the full year (not proportionately) has been provided for. It is thus an extra dividend paid during the year requiring no need of approval of the Annual General Meeting. It is paid in cash.

Type # (iii) Stock Dividend:

Stock dividend is in the form of issue of bonus shares to the equity shareholders in lieu or addition to the cash dividend. It is a permanent capitalization of earnings. It will increase the capital and reduce reserves and surpluses. It has no impact on the wealth of shareholders.

Shareholders who receive stock dividends receive more shares of the firm’s stock, but because the firm’s assets and liabilities remain the same, the price of the stock must decline to account for the dilution.

For shareholders, this situation resembles a slice of cake. You can divide the slice into two, three or four pieces and no mallei how many ways you slice it, its overall size remains the same.

After a stock dividend, shareholders receive more shares, but their proportionate ownership interest in the firm remains the same and the market price declines proportionately

Stock dividends usually are expressed as a percentage of the number of shares outstanding. For example, if a firm announces a 10% stock dividend and has 1 million shares outstanding, the total shares outstanding are increased to 1.1 million shares after the stock dividend is issued.

Type # (iv) Bond Dividend:

In rare instances, dividends are paid in the form of bonds for a long term period. The firm generally pays interest on these bonds and repays the bonds on maturity. Bond dividend enables the firm to postpone payment of cash.

Type # (v) Property Dividend:

Sometimes, dividend is paid in the form of assets instead of payment of dividend in cash. The distribution of dividend is made whenever the asset is no longer required in the business such as investment or stock of finished goods.

But it is however important to note that in India, distribution of dividend is permissible in the form of cash or bonus shares only. Distribution of dividend in any other form is not allowed.

Top 6 Significance of Dividend Policy – Resolves Investors’, Uncertainty, Investors’ Desire for Current Income, Institutional Investors’ Requirement and More…

Investors prefer stable dividend policy of the company and will be willing to pay a premium on shares of a company having stable dividend policy. The stable dividend policy is also in interest of the company itself, as it enhances the reputation of the company in the market.

Significance of dividend policy are as follows:

Significance # 1. Resolves investors’ uncertainty

The investors do not like the unstable dividend policy of the company. Stable dividend policy of the company boosts the confidence of shareholders and they make in mind that the company will also pay a dividend in a non-profit period.

In case of abnormal profits, the amount of dividend is increased by the company. Thus, the stable dividend policy of the company removes uncertainty of payments in the mind of shareholders.

Significance # 2. Investors’ desire for current income

Investors, usually, prefer current income over the capital gains. Dividends are like wages and salaries for many investors, like—old age and retired persons, women investors. This class of investors needs the regular income to meet their living expenses.

The stable dividend policy provides regular and upward moving income to the investors. Unstable dividend policy creates uncertainty about dividend payments. The investors believe that current income is better than future income because the future is uncertain.

Significance # 3. Institutional investors’ requirement

The institutional investors also invest in shares of the companies. Various government bodies prepare a list of companies/securities in which institutional investors, like—pension funds, insurance companies, banks and other institutional investors may invest. The recommendatory list is prepared on certain criteria including uninterrupted pattern of dividends.

Significance # 4. In India, financial institutions

Like—IDBI, LIC, IFCI and certain other financial institutions, invest in corporate securities. These institutional investors generally invest in shares of companies that use to pay regular dividends. Thus, the stable dividend policy of a company is a pre-requirement for investment by institutional investors in its securities.

Significance # 5. Raising additional finances

The stable dividend policy is advantageous to the company in raising further funds from the market. The investors preferably invest in securities of a company paying regular dividends.

The stable dividend policy also enhances the reputation of the company in the market and market may have more confidence in the company. These factors help in raising additional finances when the company requires these for investment in profitable opportunities.

Significance # 6. Informational contents

The stable dividend policy of a company generally conveys the view of management that the future of the company is better. A company not performing well cannot sustain the stable dividend payments. Thus, stable dividend policy signals the informational contents about the performance of the company.

If a company is making loss or earning lower profits and paying stable dividends for a number of years, then there is something wrong in the function of the firm. The market evaluates the companies on the basis of informational contents of the companies. Stable dividend policy signals positive contents about the company.

Dividend Policy – Importance of Dividend Decision: Investors’ Preference for Dividends, Informational Content of Dividend and More…

Importance of dividend decision are as follows:

i. Investors’ Preference for Dividends:

There is a class of investors who prefer dividends over capital gain. This class primarily includes old aged, retired and more risk averse investors who need current income in the form of dividends to meet their expenses.

ii. Informational Content of Dividend (Information Signaling):

Dividend payments convey important information about the company’s performance and future prospects. Hence For example- if a firm followed a stable dividend policy over a long period of time and now it is increased then investors may think that the future prospects of the company are promising.

Basically, the idea is that management, instead of announcing about the company’s future prospects can increase or decrease dividends depending on the situation and convey important information.

It is said that action speaks louder than words. Hence if a company increases its amount of dividend in expectation for higher profitability then the impact would be much better than when it reports in its annual report about the expected profitability. Moreover, statements or words may be misinterpreted while dividend payments convey the precise and correct information.

iii. Bird-in-Hand is Better than Two in Bush I.E. Resolution of Uncertainty:

It is often said that a bird in hand (i.e. dividends) is better than two in bush (i.e. capital gain). Payment of dividends resolves uncertainty about the future. Capital gains are realized in the future and future is uncertain, while dividends are paid at present and hence payment of dividends is considered better than capital gain from the viewpoint of a risk averse investor.

iv. Distribution of Temporary Excess Cash:

Payment of dividends is a good usage of temporary excess cash. This is because if the company does not have profitable investment opportunities then it makes sense to distribute excess cash to the shareholders so that they can invest it somewhere else and earn a good return. Cash rich companies which do not distribute dividends are not considered good by investors.

Dividend Policy – Forms of Dividend in a Company: Scrip, Bond, Property, Cash and Stock Dividend

Dividend that is being distributed by a company may take several forms, viz.:

(a) Scrip dividend,

(b) Bond dividend,

(d) Cash dividend, and

(e) Stock dividend.

In India, only cash dividends and stock dividends are declared and paid.

We shall give here a brief explanation of these forms of dividend:

Form # (a) Scrip Dividends:

When earnings of the company justify dividend, but the company’s cash position is temporarily weak and does not permit cash dividend, it may declare dividend in the form of scrips. In this method of dividend, the shareholders are issued transferable promissory notes which may or not be interest bearing.

Scrip dividends are justified only when the company has really earned profit and has only to wait for the conversion of other current assets into cash in the course of operations.

Form # (b) Bond Dividends:

Sometimes, the dividends are paid in bonds or notes then have a long enough term to fall beyond the current liability group. Effect of both scrip dividends and bond dividends is the same except that the payment is postponed in the bond dividends.

Form # (c) Property Dividends:

This involves a payment with assets other than cash. This form of dividend may be followed wherever there are assets that are no longer necessary in the operation of the business.

Form # (d) Cash Dividend:

Cash dividend is the dividend which is distributed to the shareholders in cash out of the earnings of the business.

Form # (e) Stock Dividend (Bonus Shares/Share):

Bonus shares are additional shares given to the shareholders without any additional cost, based upon the number of shares that a shareholder owns.

An offer of free additional shares to existing shareholders. A company may decide to distribute further shares as an alternative to increasing the dividend payout. Also known as a “scrip issue” or “capitalization issue”.

Dividend Policy – 4 Main Alternate Forms of Dividend: Bonus Shares, Stock Split, Reverse Split and Buy Back

Alternate forms of dividend are as follows:

1. Bonus Shares:

Bonus shares are issued out of the firm’s reserves & surplus. In other words through bonus issues, firms capitalize their reserves. Recently Reliance Industries Ltd. announced a huge bonus of one share for every share held by its shareholders. After issue of bonus shares proportionate holding of a shareholder remains the same.

However, EPS, market price and value per share declines. A firm can issue bonus shares only out of its reserves created from profits and share premium collected in cash only. There are certain regulations on issue of bonus shares.

Similarly, a firm can issue bonus only if its article of association authorizes it to do so. In addition, bonus cannot be given to partly paid shares and it cannot be issued in lieu of dividend. There are certain benefits of bonus shares.

For example, higher dividend income to the shareholders in future that is exempt in the hands of shareholders. After bonus issues, no. of shares outstanding in the market is increased in the market. This promotes more trading in the firm’s shares.

Price after bonus issue = (No. of shares before bonus issue ‘”‘current market price)/No. of shares after bonus issue.

2. Stock Split:

Stock split means reduction in the par value of shares. For example, par value of a share is X 100 and there is a 4:1 split. In this case, every shareholder will get four shares with a par value of Rs. 25 in lieu of every share with a par value of Rs. 100. In the share split, firm’s reserves remain intact because there is no capitalization of reserves as in the case of bonus shares.

The book value, EPS and market price reduces as in case of bonus issue due to increase in no. of shares. After splitting the shares the shareholder’s fund remain same as before share split.

Price after stock split = (No. of shares before stock split *current market price)/No. of shares after stock split.

3. Reverse Split:

It is the opposite of a stock split. In stock split, par value is reduced but in case of reverse split, par value is merged. For example, if a company’s share’s par value is Rs. 10 each and there is 1: 4 reverse split.

The par value of shares will increase to Rs. 40 per share because four shares with par value of Rs. 10 each will be merged into a single share with par value Rs. 40.

Price after reverses split = (No. of shares before reverses split *current market price)/No. of shares after reverse split.

4. Buy Back:

Buy back of share means purchasing of its own shares by the company from its shareholders. Buy back can be done by two methods. First is the Tender method in which the company offers to buy its shares back, directly from shareholders, at a specified price in a specified period, which is usually one month.

Second method is an open market purchase method in which the company buys back its shares from the secondary market. The buyback causes reduction in capital of the company and increase in EPS.

Generally companies buy back their shares when a) it has surplus cash b) it wants to increase its market price and c) wants to maintain its capital structure in the current form. There are certain advantages like increase in future dividends and strong cash flow position in future.

Price after buy back = No. of shares before buy back *current market price/No. of shares after buy back.

Dividend Policy – Informational Contents of the Dividend

Informational contents of the dividend are summarized below:

There is a wide gap in respect of availability of true information regarding the internal functioning of a company between the managers (insiders) and the shareholders (outsiders).

Thus, asymmetry exists between the managers of the company and shareholders of the company so far the availability of information is concerned.

In such a scenario, the announcement of dividend or change in dividend policy by the managers act as a medium of communication regarding prosperity or probable financial condition to the shareholders. Thus, payment of dividend has embedded in it informational content regarding proper functioning of the company.

The expression “information content of dividends” refers to the hypothesis according to which unexpected dividends are believed to convey information about future unexpected earnings in a company. This new information should allow market participants to forecast future earnings more precisely.

The hypothesis is based on the assumption that an asymmetric situation exists between corporate managers and the market participants or shareholders in the way that corporate managers possess inside information about the future prospects of the company and any change in dividend policy has signaling effects.

Signaling is the idea that one agent conveys some information about itself to another party through an action. It is used in situations where asymmetric information exists between two interested parties.

In this case, since managers know more about the internal affairs of the company than investors, investors will find “signals” in the managers’ actions to get clues about the firm.

For instance, when managers are apprehensive or doubtful about the firm’s ability to generate cash flows in the future they may keep dividends constant or may even reduce the amount of dividends . The investors will take note of this action and may choose to sell the shares of the firm.

However, if the dividends have been reduced or retained for reinvestment purposes by the company, the share price may react upwards also if the rate at return on investments by the company happens to be higher than expected rate of return of the shareholders.

In view of the above, finance managers very cautiously and carefully deal in framing dividend policy of a company since managers believe that dividend policy influences the value of their company and hence the wealth of their shareholders. However, academicians (and even some managers) question the value added by a cautiously chosen dividend policy.

Some researchers have even suggested that dividend policy is irrelevant for the value of the company. As already explained, there are different opinions with regard to the relationship between payment of dividend and value of the firm.

In real life situations, dividend decisions are seen by investors as revealing information about a firm’s prospects therefore firms are very particular about these decisions.

From the above, we can conclude that payment of dividend by a company to its shareholders not only rewards the shareholders but also conveys information about the future prospects of the company.

Theories of Dividend Policies – Tax Differential Theory, Residual Theory, 100% Payout Theory, 100% Retention Theory, Investor Rationality Theory and Span of Control Theory

The important theories of dividend policy are discussed in brief as follows:

Theory # 1. Tax Differential Theory:

According to this theory, since dividends are effectively taxed at higher rates than capital gains, investors require higher rates of return on stocks with high dividend yields. According to this theory, a firm should pay a low (or zero) dividend in order to minimize its cost of capital and maximize its value.

The tax system may tend to favour retention, and hence low dividend yield shares have been likely to be in great demand by high rate taxpayers, who prefer a low dividend payout and a high rate of earnings retention in the hope of an appreciation in the capital value of the company. Small shareholders may prefer a relatively high dividend payout rate. The dividend policy of such a firm may be a compromise between a low and a high payout.

Theory # 2. Residual Theory:

According to the residual theory of dividends, the firm should follow its investment policy of accepting all positive NPV projects, and paying out dividends if, and only if, funds are available. If the firm treats dividends as a residual, the dividend can vary highly from period to period, depending upon the investment plan and operating results of the firm.

If a firm attracts investors falling into a particular ‘dividend clientele’, it suggests that the firm should maintain a fairly stable dividend policy. The residual dividend policy is used by most firms to set a long-run target payout.

Theory # 3. 100% Payout Theory:

Rubner (1966) argued that shareholders prefer dividends and directors requiring additional finance would have to convince investors that proposed new investments offer positive increases in wealth.

This would encourage the rejection of projects which serve mainly to enhance the status and job security of managers and employees and the company can adopt a policy of 100% payout. In practice, companies do not generally pursue a target payout ratio of 100%.

Theory # 4. 100% Retention Theory:

Clarkson and Elliot (1969) put forth their argument that given taxation and transaction costs, dividends are a luxury that neither shareholders nor companies can afford and hence the firm can follow a dividend policy of 100% retention.

They argue further that successful investment opportunities are open to the firm and that there is no point in paying dividends and raising additional capital.

Theory # 5. Investor Rationality Theory:

Shefrin and Statman (1984) supported their argument based on the psychological preferences of individual investors. Their argument is that an investor who wishes to conserve his/her long-run wealth could stipulate that portfolio capital should not be consumed, only dividends.

The investor can select a dividend payout ratio that conforms to his/ her desired consumption level. Thus, even though taxes and transaction costs may favour capital gains, an investor may find cash dividends attractive and, therefore, be willing to pay the appropriate premium.

Theory # 6. Span of Control Theory:

Managers in an organization look at the cash flows generated from the operations as an important and convenient source of new capital. The professional managers prefer to have a large span of control as measured by the number of employees, sales, market value, total assets or total expenditure.

In pursuit of the managerial objective of increasing the span of control, directors are expected to prefer retention to distributions. Retentions increase status, remuneration and security of managers. Also increases in the firm’s investment schedule should result in growth in the value of shares to the extent that retained cash flows are reinvested in profitable projects.

Dividend Policy – Modigliani-Miller’s Model (M-M’s Model): Meaning, Assumptions, Example and Evaluation

Meaning:

Modigliani-Miller’s (M-M’s) thoughts for the irrelevance of dividends are most comprehensive and logical. According to them, dividend policy does not affect the value of a firm and is, therefore, of no consequence.

They are of the view that the sum of the discounted value per share after dividend payments is equal to the market value per share before dividend is paid. It is the earning potential and investment policy of a firm rather than its pattern of distribution of earnings that affects the value of the firm.

Basic Assumptions of M-M Approach:

(1) There exists a perfect capital market where all investors are rational. Information is available to all at no cost; there are no transaction costs and floatation costs. There is no such investor as could alone influence the market value of shares.

(2) There does not exist taxes. Alternatively, there is no tax differential between income on dividend and capital gains.

(3) Firm’s investment policy is well planned and is fixed for all the time to come.

(4) There is no uncertainty as to future investments and profits of the firm. Thus, investors are able to predict future prices and dividends with certainty. This assumption is dropped by M-M later.

M-M’s irrelevance approach is based on an arbitrage argument. Arbitrage is the process of entering into such transactions simultaneously as exactly balance or completely offset each other. The two transactions in the present case are payment of dividends and garnering funds to exploit investment opportunities.

Suppose, for example, a firm decides to invest in a project it has two alternatives:

(1) Pay out dividends and raise an equal amount of funds from the market;

(2) Retain its entire earnings to finance the investment programme. The arbitrage process is involved where a firm decides to pay dividends and raise funds from outside.

When a firm pays its earnings as dividends, it will have to approach the market for procuring funds to meet a given investment programme. Acquisition of additional capital will dilute the existing share capital which will result in drop in share values.

Thus, what the stockholders gain in cash dividends they lose in decreased share values. The market price before and after payment of dividend would be identical and hence the stockholders would be indifferent between dividend and retention of earnings. This suggests that the dividend decision is irrelevant.

M-M’s argument of irrelevance of dividend remains unchanged whether external funds are obtained by means of share capital or borrowings. This is for the fact that investors are indifferent between debt and equity with respect to leverage and the real cost of debt is the same as the real cost of equity.

Finally, even under conditions of uncertainty, dividend decisions will be of no relevance because of operation of arbitrage. Market value of shares of the two firms would be the same if they are identical with respect to business risk, prospective future earnings and investment policies.

This is because of rational behaviour of investors who would prefer more wealth to less wealth. Difference in respect of current and future dividend policies cannot influence share values of the two firms.

M-M approach contains the following mathematical formulations to prove irrelevance of dividend decision.

The market value of a share in the beginning of the year is equal to the present value of dividends paid at the year-end plus the market price of the share at the end of the year, this can be expressed as below –

Thus, the total value of the firm as per equation (37.2) is equal to the capitalised value of the dividends to be received during the period, plus the value of the number of shares outstanding at the end of the period, less the value of the newly issued shares.

A firm can finance its investment programme either by ploughing back of its earnings or by issue of new shares or by both. Thus, total amount of new shares that the firm will issue to finance its investment will be –

On comparison of equation (13) with equation (11) we find that there is no difference between the two valuation equations although equation (13) has expressed the value of firm without dividends. This led M-M to conclude that dividend policy has no role to play in influencing share value of a firm.

Evaluation of M-M’s Model:

M-M model of dividend irrelevance is laid down on a number of simplifying and potentially restrictive assumptions. In a world where taxes, transaction costs and a host of other complexities do exist, it should come as no surprise that the irrelevance proposition is only a starting point for our discussion.

The following paragraphs are devoted to review and critically examine the more important arguments against irrelevance.

(a) Risk Aversion:

The first argument set forth in support of the relevance of dividend policy is that investors are always cautious about the future which is uncertain and unpredictable. They are interested more in short-run income which is more certain and assured than in the long-run earnings that are highly unpredictable.

Since dividend averts risk in respect of availability of income to investors, they may give greater weightage to expectation concerning present dividends than to beliefs as to what the trend in price and dividends might be over the long-run.

Furthermore, the present value of income received in the short-run is higher than the value of future earnings. In view of this, Gordon holds that stockholders can remain neutral between dividends and capital gains. They prefer early resolution of uncertainty and are willing to pay a higher price for the stock that offers greater current dividend all other things remaining constant.

(b) Desire for Current Income:

Investors also prefer regular dividend payment to future capital gains because that helps them to satisfy their current requirements. However, this argument is not accepted universally.

It is argued that stockholdings can liquidate a portion of their stockholders at times when they need money to meet their requirements. Since with perfect markets and no taxes the homemade dividends are perfect substitutes for corporate dividends, there is no reason to anticipate that increasing risk and desire for current income will alone create investor dividend preferences.

It is true that stockholders can procure funds by liquidating their shares and make use of these in whatever manner they like as in the case of dividend income. But under conditions of uncertainty, share prices oscillate and certain stockholders may be averse to disposing off shares for income at fluctuating prices.

Alongside this, it is not always easier to sell a small portion of stock periodically incurred for sale of securities which will consume a portion of income. Thus, to avoid risks and inconveniences and costs involved in liquidation of shares, stockholders have definite preference for dividend income.

(c) Information Content of Dividends:

In arguing for the significance of dividend policy it has been contended that dividend decision affects share values because amount of dividends and the manner in which they are distributed are considered a significant piece of information regarding the future earnings capacity of the firm; a high dividend exhibiting small but steady growth is looked upon as an index of stability of the organisation.

Empirical study of Richardson Pettit has substantiated this notion. The main finding of Pettit’s study is that the market reacts to announcements of dividend changes and these announcements convey significantly more information than earnings announcements.

M-M do not disagree with the possibility of the information effect of the dividend but they continue to maintain that it is not dividend as such but present and expected future performance of the organisation which affects value of the firm and dividend is only a reflector of these variables.

(d) Sale of Additional Stocks at Lower Prices:

Irrelevance doctrine is based on the argument that the firm distributing all of its earnings will be able to sell additional stocks at current prices. In order to tempt new investors or existing ones to buy new stocks the company may offer lower price.

Linter argues that the equilibrium price of a share of stock will tend to decline in correspondence to sale of additional stocks for replacement of dividend. Thus, ceteris paribus, this mix of equity share capital in capital structure would result in a fall in total value of equity of the corporation which implies a definite preference for retention as opposed to dividend payments.

(e) Differential Tax Treatment of Dividends and Capital Gains:

The tax treatment of dividends as distinct from capital gains explains investors preference for income retention. Under the existing provision of Indian Income- tax Act an investor is required to pay tax on dividend income at an ordinary income-tax rate applicable to the investor’s income which is usually higher than the capital gains tax rate.

Moreover, capital gains will be taxable only when stocks are sold while dividend income is taxed immediately when it is paid. For these reasons, there is a propensity among some stockholders to prefer retention of earnings to current dividends.

Despite the pervasiveness of the differential tax effect, there are two tax provisions that have an opposite effect. One is the tax exemption of dividend income up to Rs.7,000. Although dividends are treated as ordinary income for tax purposes, there is Rs.10,000 ceiling up to which dividend income is not taxed at all.

This provision is very likely to create a preference for current dividends on the part of small investors. For corporate investors, intercompany dividends received by a domestic company from domestic companies belonging to certain priority industries like fertilizers, paper and pulp, cement and pesticides are totally exempted.

Accordingly, there would be a preference for current dividends on the part of these investors. However, relatively larger investors will continue to have definite preference for retention of earnings.

Furthermore, since inter corporate dividends received from non-specified companies continue to be taxed at 60 per cent rate, corporate investors having employed their resources in the above group of companies would have preference for retention of earnings.

(f) Transaction Costs:

Existence of transaction costs in the stock market also justifies the strong bias of investors for retention of earnings. Two types of transaction costs are relevant for dividend policy — one is the cost borne by the company when it visits the market for securing funds and the other is the cost borne by investors when they trade securities.

The costs to a company of raising external capital are of four basic types: legal, selling, underwriting and underpricing. These costs vary significantly with quantum and kinds of capital raised.

In view of this, the firm gets less than a rupee after floatation cost per rupee of external financing. These costs can be avoided in case the firm decides to retain earnings. This is why internal financing is always cheaper than external financing.

Transaction costs, which investors desiring to liquidate a portion of his holdings have to bear, tend to restrict the arbitrage process. Because of this, such stockholders with high consumption desires in excess of current dividend income would like the firm to pay additional dividend rather than liquidate his holdings. In contrast to this, the stockholders not desiring dividends for current consumption would prefer to reinvest funds in the company.

Thus, due to transaction cost factor, while certain groups of investors have definite bias for dividend income, others would have preference for retention of earnings.

(g) Erratic Behaviour of Investors:

M-M’s proposition that investors always act rationally is not necessarily true. An investor may buy an undervalued stock even though he expects the share price to fall further and he may sell an overvalued stock even though he expects the market to show a rising tendency.

The above analysis posits that in the real world, capital market conditions are neither perfect nor does the investor always behave rationally and taxes and floatation costs do exist. In view of these factors, it would be reasonable to contend that dividend policy does affect the price of a share of stock.

Informational contents to dividend further add to the significance of dividend decision. During a period of uncertainty the importance of dividend decision becomes more pronounced because dividend income currently available minimises risks involved in future gains.

Miller and Modigliani’s arguments of irrelevance of dividend decision are based on such assumptions as are not found in the real world. Thus, dividend policy decisions would have a definite impact on share values.

Dividend Policy – 8 Major Factors Affecting the Dividend Division of a Firm: Liquidity, Requirement of Funds, Cost, Control, Expectation, Taxes and More…

The following factors affect dividend decision of a firm:

Factor # 1. Liquidity:

Liquidity plays an important role in dividend decisions. A company will have to pay a dividend within 14 days from the date of declaration. A firm, having high liquidity despite low profitability, prefers high payout and a firm, having low liquidity, despite high profitability prefers low payout.

Factor # 2. Requirement of Funds:

The firms preferring to finance its capital expenditure out of its internal resources will go for a low payout ratio.

Factor # 3. Cost:

Financing from external equity is costlier than financing from retained earnings because fresh issues are made at a discount. This leads to underpricing of IPOs.

Factor # 4. Control:

Financing from external equity causes loss in control except in case of right issues. This is so because in case of fresh issue, existing shareholders share their control with new shareholders, but in case of financing from internal sources shareholding is not affected.

Factor # 5. Expectation:

Shareholders expectations also play a very important role in determining dividend payout ratio. In case shareholders show their interest in the current dividend, the companies pay a higher dividend. However, in case shareholders are more interested in capital gains, firms may declare lower payout.

Factor # 6. Taxes:

Dividend from any domestic company is exempt in the hands of the recipient. However, the company paying dividends has to pay a distribution tax on its distributed profit @ 16.995%. The long-term capital gain arising on transfer of these shares is also exempt in the hands of the transferor.

Factor # 7. Access to external financing:

If a firm has easily accessible external financing resources then that firm may declare higher payout. However, in case of a firm not having access to external financing, lower payout is declared. It is because these types of firms mainly depend upon their internal sources.

Factor # 8. Inflation:

During the period of inflation, generally, companies declare lower payout or no dividend. It is because companies may find their depreciation provision not enough to replace its assets. The depreciation provisions are made based on original cost of assets.

Approaches to Dividend Policy – Irrelevance Approach (Modigliani and Miller) and Relevance Approach (Walter and Gordon)

One group of economists believes that there is no impact of dividend policy on the value of the organization. It means that whether the management retains the profit in the business or distributes it among shareholders, the value of the organization would not be affected by it. This is known as the irrelevance approach.

On the other hand, other groups of economists believed that dividend policy influences the value of the organization. It implies that if the profit would be retained or distributed among the shareholders, it affects the value of the organization. This is known as the relevance approach.

Let us now discuss these approaches in detail:

Approach # 1. Irrelevance Approach (Modigliani and Miller):

The irrelevance approach states that the dividend policy does not influence the value of an organization. It argues that the dividend is a residual, which is paid after paying rate of interest, corporation tax and other liabilities out of profit.

The irrelevance approach states that the decision to pay the dividend depends upon the availability of investment opportunities. If the organization has profitable investment opportunities then the profit would be ploughed back in the business.

Otherwise, the dividend would be distributed among the shareholders, so that they can invest in other profitable projects and earn high returns. The organization takes the decision to invest profit by comparing the return on the investment (r), and the cost of the capital (k).

If r > k, then the profit would be ploughed back in the business. However, if the r < k, then the profit would not be invested further in the organization.

This approach is based on the assumption that the shareholders prefer appreciation in the capital rather than regular dividend. If the shareholders are convinced that the organization would generate more profit by investing the profit then they would not demand a dividend.

This happens because the shareholders believe that more profit would result in the capital appreciation, which increases the market value of their shares. However, if the investment project of the organization starts incurring loss, the shareholder would prefer to get back their dividend.

There is a very popular theory in support of this approach given by Modigliani and Miller. This theory is also known as the MM model. As per the MM model, the dividend policy has no impact on the value of an organization (or market price of shares); rather it is the investment decision that affects the organization’s value.

According to Modigliani and Miller’s hypothesis “under condition of perfect capital market, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on market price of shares”

The MM model of irrelevance approach is based on the following assumptions:

i. The conditions of perfect market exist

ii. Investors are rational and the securities are infinitely divisible

iii. Absence of transaction and flotation cost

iv. Corporation tax does not exist

v. Investment policy would not change

vi. Investors’ future earnings can be predicted with perfect certainty

The MM model is based on the arbitrage process to determine the irrelevance of the dividend decision. In the arbitrage process, the organization enters into two transactions, which completely offset each other.

These two transactions are paying dividends and raising external loans. It has been assumed that the organization distributes dividends among the shareholders, and raises the same amount of capital from the market.

The arbitrage condition involved in these transactions states that the payment of the dividend would be offset by external borrowing of the fund. When the organization pays a dividend, then the market value of its shares decreases. Therefore, the gain of the shareholders in the form of dividend would be neutralized by decrease in the value of shares due to dividend distribution.

As a result of this, the position of the shareholders would remain unchanged. Therefore, the decision to distribute dividends is irrelevant, as it does not affect the value of an organization.

The mathematical representation of the irrelevance approach is as follows:

P₀= [1 / (1+K_e)] x (D₁ + P₁)

Where,

P₀ – Current Market Price

K_e – Cost of Equity Capital

D1 – Dividend received at the end of period 1

P1 – Market price of a share at the end of period 1

However, this approach is criticized on the following grounds:

i. Believes that the perfect market conditions exist, which is a rare phenomenon

ii. Assumes that there is no taxation and transaction cost, which is not possible in a real situation

iii. Does not differentiate between retained earnings and cost of capital

iv. Assumes that information is freely available about all the transactions, which is not possible in a real situation

v. Ignores the risk involved in the future investments

Approach # 2. Relevance Approach (Walter and Gordon):

The relevance approach states that the dividend policy plays an important role in determination of the value of an organization. It is based on the assumption that the shareholders give priority to current consumption rather than future earning, which involve the risk element.

The economists who were in support of the relevance approach include Walter and Gordon. They have given their hypothesis in favor of the relevance approach separately as Walter’s model, and Gordon’s model.

According to the model given by Walter, dividends are considered as relevant and the dividend policy and investment policy of an organization are interrelated. The Walter model lays emphasis on the relationship between return on organization’s investment (r) and the cost of capital (K).

At any point of time, dividend policy can be determined by finding relationship between r and K, which has been explained in the following points:

i. r > K – Implies that the rate of investment is greater than the cost of capital. In such a situation, the organization would retain its earnings to invest in the project and does not distribute dividends.

ii. K> r – Implies that the rate of investment is lesser than the cost of capital. In such a situation, the organization would not retain its profit to invest in the project and may distribute the dividend.

iii. K= r – Implies that the rate of investment is equal to the cost of capital. In such a situation, the organization would not generate either profit or loss from the project. Therefore, the organization would be indifferent whether to retain the earnings or distribute the dividend.

The Walter’s model is based on the following assumptions:

i. External sources of capital are not used, only retained earnings are used to distribute the dividend or finance a project

ii. The values of r and k remain constant

iii. An organization exists for a long period

iv. Earnings per Share (EPS) remains constant in a given period

The formula used to make dividend decision is as follows:

P= D / (K_E– g)

Where,

P – Price of Equity Shares

D – Initial Dividend

Ke – Cost of Capital

g – Retained Earning

The limitations of the Walter model are as follow:

i. Assumes that only retained earnings have been used for the investment, which is a hypothetical situation

ii. Uses unrealistic assumption that the value of r remains constant

iii. Does not consider risk factor as it assumes the EPS is constant

Gordon’s model also upholds the view that dividend policy is relevant for the organization. The model is also known as bird in the hand argument because this model is based on the assumption that shareholders prefer to receive dividend in the present situation.

As per Gordon’s model, the shareholders believe that the future earning is uncertain in nature because it involves risk factors. If the organization needs to invest the retained earnings in projects then it should ensure the shareholders that they would be paid a premium for bearing the risk of future investment.

The Gordon’s model is based on the following assumptions:

i. The organization has existed for a long period.

ii. Increase in investment would not affect the value of r and k.

iii. No external fund, such as debt or equity, would be used to finance various investments.

iv. Retention ratio (br) and retained earnings (g) are constant and g = br

The formula used for the determination of the dividend decision is as follows:

P = D / (K_e– g)

When the organization invests retained earnings and earns more profit, then it may pay more dividend to shareholders.

This increase in dividend is calculated with the help of following formula:

P= [E (1 – b)] / (k_e– br)

Where,

P – Price of the Share

E – EPS

B – Retention Ratio

(1-b) – Dividend Payout

K_e – Cost of Capitalization

br = g – Growth Rate

Dividend Policy – 2 Possible Approaches to Dividend Decisions: As a Long-Term Financing Decision and As a Maximisation-of-Wealth Decision

Two Possible Approaches to Dividend Decisions:

Dividend policies affect both the long-term finance and returns available to shareholders.

Therefore, management can follow two possible approaches while making a dividend decision:

(1) As a Long-Term Financing Decision:

As per this approach, all earnings after taxes can be seen as long-term funds for the business. By paving cash dividends, the available resources of the firm decrease. Less funds become available for the development of the firm as a result of which either the growth of the firm slows down or the firm has to procure funds from other sources.

Firm can take decision to retain its profits in the following two situations:

(i) Sufficient Profitable Projects are Available:

Various firms can attain their growth goal by accepting highly profitable projects. Till such projects are available, the firm may decide to retain its profits to the maximum extent for financing them.

(ii) Capital Structure Needs Equity Funds:

Firm has various available sources for long-term funds. Use of excessive loan capital in the capital structure increases risk. Therefore, in order to save the firm from risk, proper balance between equity funds and debt funds is to be maintained.

Besides, to issue equity share capital, issuing expenses have to be borne by the firm. But retained earnings are cheaper because for it no such issuing expenses are to be incurred. In such a case also, firms can decide to retain the profits.

(2) As a Maximisation-of-Wealth Decision:

From this viewpoint, management feels that dividend causes a great impact on the market price of the shares. High rate of dividend raises the price of shares. Therefore, management should declare a maximum dividend to the shareholders to meet their expectations.

Dividend Policy – Dividend Payout Ratio (With Significance and Interpretation)

Dividend Payout Ratio is summarized below:

The dividend payout ratio is a way of measuring the fraction of a company’s earnings that are paid to investors in the form of dividends rather than being reinvested in the company in a given time period (usually one year). In other words, this ratio shows the portion of profits the company decides to keep for funding operations and the portion of profits that is given to its shareholders.

The amount that is not paid out in dividends to shareholders, is held by the company for reinvestment in the business concern, or may be used for any other purposes, such as retirement of debt and so on. The amount that is kept by the company to be ploughed back is called retained earnings.

The dividend payout ratio (D/P ratio) is calculated by dividing the total dividend paid to equity shareholders by the net income available to them for that period as follows –

= Total dividends paid/Net income after tax

Net income shown in the formula may be found in the company’s income statement. It is commonly expressed as a percentage. To illustrate, let us assume that the M/s Angad Ltd. is Rs.25,00,000 in the previous year and it paid out Rs.10,00,000 as dividends to its equity shareholders.

The dividend payout ratio is:

= (10,00,000 / 25,00,000) x 100 = 40%

The dividend payout ratio should be analyzed over multiple years so that trend, if any, may be interpreted. Dividend payout ratio can also be calculated by dividing the dividends per share by the earnings per share.

= Annual dividend paid per share/Earnings per share

The numerator in the above formula is the dividend per share paid to equity shareholders only. It does not include any dividend paid to preference shareholders.

Alternatively, it can also be found by subtracting retention ratio from 1

= 1 – retention ratio

The retention ratio = Retained earnings/Net income and the dividend payout ratio together equals to 1 or 100% of net income as whatever amount not paid in dividends is retained by the company to reinvest for expansion. Thus, when the dividend payout ratio is 1 or 100%, the retention ratio is 0 or 0% as it implies that no earnings have been retained for growth.

Alternatively, a company that pays no dividends would have a retention ratio of 1, which means that the company reinvests all of their net income for growth. However, a negative retention ratio implies that the payout ratio is greater than 100% and the company is using its cash reserves to pay dividends. This situation is not sustainable, and may result in the eventual termination of all dividends or the financial decline of the business.

Significance and Interpretation:

The determination of D/P ratio is referred to as the dividend decision of the firm or dividend policy. The dividend payout ratio is an important indicator of the company’s performance from an investor’s point of view. It also provides an indication of future growth potential of a company.

People invest in a company expecting a return on their investment, which comes from two sources- capital gains and dividends. The return from these two sources is interrelated. A high dividend payout ratio means that the company is reinvesting less earnings in future projects, which in turn means fewer capital gains in future periods.

Similarly, a low dividend payout ratio means that the company is keeping a large portion of its earnings for growth in future and thus, may result in higher capital gains in future.

Some investors prefer companies that provide high potential for capital gains while others prefer companies that pay high dividends. Dividend payout ratio helps each class of investors to identify the companies to invest in. Whether a payout ratio is good or bad depends on the intention of the investor.

A high payout ratio is usually preferred by those investors who purchase shares to earn regular dividend income and a low ratio is good for those who seek appreciation in the value of equity shares in future.

Therefore, the dividend payout ratio is used by the investors to decide whether to invest in a profitable company that pays out dividends or in a profitable company that has a high growth potential.

The dividend payout ratio analysis is important as the investors are mainly concerned with a steady stream of sustainable dividends from a company. A consistent trend in this ratio is usually more important than a high or low ratio. For instance, investors can assume that a company that has a payout ratio of 20% for the last ten years will continue giving 20% of its profit to the shareholders.

Conversely, a company that has a downward trend of payouts sends a wrong signal to investors. For example, if a company’s ratio decreases by a percentage point every year for the last five years, this may be an indication of poor operating performance of the company.

The dividend payout ratio should be analyzed in the context of industry and other ratios. Such as dividend yield ratio, P/E ratio and so on.

Dividend Policy – Right Issue of Shares: Meaning, Reasons, Example, Valuation, Advantages and Disadvantages

Meaning of Rights Issue of Shares:

A rights issue is when a company issues its existing shareholders a right to buy additional shares in the company. The company will offer the shareholder a specific number of shares at a specific price.

The company will also set a time limit for the shareholder to buy the shares. The shares are often offered at a discounted price to encourage existing shareholders to take the company up on their offer.

If a shareholder does not take the company up on their rights issue then they have the option to sell their rights on the stock market just as they would sell ordinary shares, however their shareholding in the company will weaken.

Reasons for a Rights Issue of Shares:

A company will offer more shares to its shareholders to raise extra money for the company. Compa-nies with a poor cash flow will often use a rights issue to increase cash flow and pay off existing debts.

Rights issues however are sometimes issued by companies with healthy balance sheets in order to fund research and development projects or to purchase new companies.

Discounted shares issued by a company can be tempting but it is important to find out first the reason for the rights issue of shares. A company, for example, may be using the rights issue as a quick cash fix to pay off debts masking the real reason for the company’s cash flow failing such as bad leadership. Caution is advised when offered with a rights issue.

Example of a Rights Issue of Shares:

i. Company ABC Mining’ has 10 million shares at a share price of Rs.8 (market capitalization Rs80million).

ii. Joe Bloggs owns 1,000 shares worth Rs.8,000.

iii. ABC Mining needs to raise Rs.30 million to research new mining locations.

iv. ABC Mining issues 5 million new shares @ Rs. 6 each (to raise Rs. 30 million, a 25% discounted price).

v. This is classed a 2 to 1 rights issue (10 million old shares : 5 million new shares)

vi. Which means every 2 shares you own ABC mining will issue another 1 share.

vii. This means Joe Bloggs is being issued with the right to buy a further 500 shares at $ 6 (Rs. 3,000)

Joe Bloggs can either-

1. Buy the further 500 shares for Rs. 3,000.

2. Ignore ABC Mining’s rights issue. This will result in Joe Bloggs shareholding will be diluted along with the value of his current shareholding. This option is not usually advised.

3. Sell his rights on the stock market and make a profit (providing the rights are renounceable, if a company issues non-renounceable right then they cannot be traded

As you can imagine the stock price is likely to change after a rights issue of shares. This is called the ex-rights share price. It is possible to estimate the ex-rights share price by;

i. Taking Joe Bloggs original shareholding of 1000 shares @ Rs. 8.00 worth Rs. 8,000

ii. Taking Joe Bloggs new 500 shares @ Rs. 6.00 worth Rs. 3,000

iii. Adding the total values together Rs. 8,000 + Rs. 3,000 = Rs. 11,000

iv. Dividing the total value (Rs. 11,000) by the total number of shares (1500) = Rs. 7.33 per share.

However the ex-rights price can be influenced by many other factors such as the reason for the rights issue, the general direction of the stock market etc.

Valuation of Right Shares:

According to Sec. 81 of the Companies Act, 1956, a company, if it so desires, can increase its share capital by issuing new shares. In that case, the existing shareholders must be given the priority of purchasing those shares according to their paid-up value. Since the existing shareholders have got such right to purchase the newly issued shares, they are called Right Shares.

In order to make a proper valuation of rights relating to Right Shares, the market value of the old hold-ings and the total issue price of the new holdings must be added and the same must be divided by the total number of new and old holdings. Value of right will be the difference between the result that is obtained and market value of shares. Hence,

The Value of a Right:

To make the offer relatively attractive to shareholders, new shares are generally issued at a discount on the current market price.

Value of a right = theoretical ex rights price – issue (subscription) price

Since rights have a value, they can be sold on the stock market in the period between

i. The rights issue being announced and the rights to existing shareholders being issued, and

ii. The new issue is actually taking place.

Advantages and Disadvantages of Rights Issues:

Advantages:

i. It is cheaper than a public share issue.

ii. It is made at the discretion of the directors, without consent of the shareholders or the Stock Exchange.

iii. It rarely fails.

iv. Existing shareholders’ equity stakes are not diluted, provided they take up their rights.

Disadvantages:

i. There is a limit to how much can be raised through this method as existing shareholders are only willing to invest so much. A rough rule of thumb is that a rights issue could raise up to 25% of the existing equity value of the firm.

ii. If shareholders do not take up their rights, then their shareholding will be diluted.

Dividend Policy – Cash Dividend: Meaning and Forms

Meaning of cash dividend:

We have seen that Dividend is the return that a company pays to its members or shareholders at the end of a year as a share of profit. However, cash is not the only form in which the shareholders may be rewarded. The dividend or reward to the shareholders may be given in the form of stocks or shares of the company. This is known as the stock dividend.

Cash dividend may be given in forms:

(a) Bonus Shares

(b) Stock Split.

Let us first look at ‘Bonus Shares’. These are the fully paid- up shares, which a company gives to its shareholders free of any charge. If a company does not pay its full profit to its shareholders the amount is transferred to its reserves.

Over the years the reserves accumulate and the book value of the share increases. No doubt, the companies reward the shareholders by way of higher dividends, but another way, which is preferred by the shareholders, is to give bonus shares.

These bonus issues increase the equity holdings of the shareholders and, therefore, in the eyes of the shareholders, are more rewarding. However, technically speaking, bonus shares should have no effect on shareholders’ wealth, because only the reserves are being converted into shares and it is only an accounting entry. It is generally experienced that, after the bonus issue, there is a corresponding fall in the price of the share and, therefore, shareholders’ wealth, remains the same.

However, there are psychological reasons because of which shareholders attach a higher value to a bonus issue. Firstly, they have a psychological satisfaction of having a greater number of shares of the company without spending anything and secondly, an issue of bonus shares is an assurance of higher dividend income to the shareholders in the future. Thirdly, it is a tax saving exercise also.

Although, dividends are tax-free in the hands of shareholders in many countries, companies have to pay a tax on dividend distribution. In contrast, bonus shares are tax free and shareholders can earn a tax-free income by selling the shares in the market, if they so wish, That is why; bonus issues may sometimes be preferred over cash dividend.

Another method of rewarding the shareholders, by way of stocks is called the ‘stock split’. In this case, the stocks are divided into smaller denominations. For example, a fully paid up share of Rs.10 each may be subdivided into 5 shares of Rs. 2 each.

A shareholder having 100 shares earlier will instead be issued 500 shares of Rs. 2 each. This stock split gives a nominally greater number of shares in the hands of shareholders, with the value of each share reduced proportionately. Hence, there is no real gain to the shareholders. Their wealth remains the same. The gain to the shareholders is only notional.

This method was more popular earlier, when shares in a stock market were traded in a ‘lot’. These tradable ‘lots’ used to be of 50, 100 or 200 shares. When the value of shares became very high the value of one lot became so exorbitant that small investors were weeded out of the trading of these shares. For example, if the market price of a share was Rs. 500 and it was to be traded in lots of 100 shares, then the value of one transaction became a minimum of Rs. 50,000 and in multiples thereof.

This made trading in the shares very difficult and often adversely affected its trading in the stock markets. In order to improve the trading of stocks and to improve its liquidity in the market, the companies used to resort to stock split.

This reduced its face value and the market value. By stock split, the value of one lot used to come down substantially, which facilitated its trading. However, now, with the introduction of electronic dematerialized trading of shares, there is no concept of a ‘lot’ and shares can be traded in any number. This has reduced the importance of stock split for this purpose.

In spite of this change of scenario, the stock split is still resorted to, because of the psychological reasons and also because the shareholders may earn cash by selling some of the additional equity shares, which they have got by stock split. Another reason for stock splitting is that the shareholders may also have an assurance of higher dividend in future.

Dividend Policy – Stock Dividends: Meaning, Kinds, Merits and Limitations

Meaning of stock dividend:

Stock Dividend is in the form of issue of Bonus shares to the existing shareholders in lieu or addition to the cash dividend. It is the permanent capitalization of earnings. This will increase the capital and reduce the reserves and surpluses. Thus, the net worth is not affected by Stock dividend. Thus, the stock dividend has no impact on the wealth of shareholders. A stock dividend is commonly known as the melon.

According to Henry Hoagland, “But a melon is really a lemon so far as cash dividends are concerned. This is so because it presents future cash dividends until a new surplus has been built up from the future earnings”.

Stock dividends may be issued in the following kinds:

(a) Equity shares to Equity shareholders;

(b) Preference share to preference shareholders;

(d) Preference share to equity shareholders.

Merits of Stock Dividends:

(a) But stock dividends are not taxable on the issue of Bonus share. Only when they are sold, those capital gains are taxable subject to exemptions.

(b) Indication of higher future profits.

(d) Market value of share will rise.

(e) Psychological value to the shareholders.

To the Company:

(a) Cash is preserved and utilized for production purposes or investment in fixed assets for expansion or for new ventures.

(b) When cash is not sufficient to pay dividends, stock dividend is the best form that satisfies the shareholders.

(d) Capital base is strengthened.

(e) When profits are very much higher in future, it will be better for the company to lower the dividend rate of the large number of shares including the bonus share already issued. The base will be larger.

(f) Because of conservation of cash, creditors will be happy.

Limitations of Stock Dividends:

(a) Stock dividend has no impact on the wealth of shareholders.

(b) It is costlier to administer the issue of Bonus share, i.e., issue of share Certificates etc., than to pay cash dividends which will involve a mere issue of dividend warrants.

(d) The existing dividend rate may not be maintained, in most of the cases, after the issue of stock dividend because of a larger capital base.

(e) If ROI is declined on the basis of a larger capital base, the price of share will decline. Shareholders will lose not only on the original shares but also on the Bonus shares.

Dividend Policy – Bonus Shares: Meaning, Conditions, Procedure, SEBI Guidelines, Advantages and Disadvantages

Meaning of Bonus Shares:

Bonus shares mean a gift or premium in form of stock by a company to its shareholders. It may be stated as an extra dividend to shareholders in a joint stock company. From surplus profits in the legal context a bonus share is neither dividend nor a gift. It is governed by regulations of the company law that it can neither be declared like a dividend nor gifted away.

Definition – Bonus shares are additional shares given to the current shareholders without any additional cost, based upon the number of shares that a shareholder owns. These are the company’s accumulated earnings which are not given out in the form of dividends, but are converted into free shares.

Conditions for Issue of Bonus Shares:

For making an issue of bonus shares, the following conditions must be complied with:

1. Sufficient undistributed profits must be there.

2. Articles must permit such an issue.

3. Suitable resolution by the Board of Directors must be passed.

4. Formal approval of the shareholders in a general meeting must be secured.

5. Permission of the ‘Controller of Capital Issues’ must be obtained under the Capital Issues Control Act, 1947, regardless of the amount involved. There is no lower exemption limit in case of bonus share because care is taken to see that the company does not get over-capitalised in the process, and that the issue satisfies the guidelines prescribed by the Government in that regard.

It is worth noting here that the said permission is required to be obtained by every company whatsoever—private company, banking and insurance company, government company and public company.

Procedure on Issue of Bonus Shares:

The secretarial procedure followed in the issue of bonus shares may briefly be stated as follows:

1) To ensure that Articles permit the issue of bonus shares. If not, the Articles should be suitably amended.

2) To ensure that the bonus issue is within the limits of authorized share capital of the company. If not, memorandum and articles have to be suitably amended.

3) To convene a meeting of the Board of Directors –

i. To consider the proposal for ‘Bonus Issue’ and the proportion in which the same should be issued.

ii. To fix up the date, time, place and agenda of the extraordinary general meeting to be convened for securing the approval of the shareholders.

iii. To approve the date of closing the Register of Members and transfer books.

4) If the company’s shares are listed on a Stock Exchange, to notify the Exchange of the date of the Board meeting which will consider the issue of bonus shares and further to notify the Exchange of the decision in that regard immediately after a formal decision has been taken.

5) To issue notices to members relating to the aforesaid general meeting along with the explanatory statement.

6) To pass a resolution in the general meeting, as per Articles. If it is a special resolution a copy thereof to be filed with the Registrar within 30 days.

7) To obtain the permission of the Controller of Capital Issues regardless of the amount involved.

8) To obtain the approval of stock exchange(s) for the procedure to be followed for allotment of bonus shares.

9) To obtain the approval of the Reserve Bank of India, under the foreign Exchange Regulation Act, 1973, for allotment of bonus shares to non-resident members, if any.

10) To prepare ‘provisional allotment sheets’ i.e., the lists of members showing their present shareholding and the number of bonus shares to which they are entitled.

11) To convene another Board meeting – (i) to approve the ‘provisional allotment sheets’ and to pass an allotment resolution, and (ii) to approve the date of closing the Register of Members and transfer books.

12) To give a public notice in some leading newspaper regarding the closure of the Register of Members and transfer books for the purpose of issue of bonus shares.

13) To issue Allotment Letters to the members along with a circular-explaining how the allotment has been made.

14) To file with the Registrar within 30 days of allotment a ‘Return of Allotment’ stating – (i) the number and nominal amount of the bonus shares so allotted; (ii) names, addresses and occupations of the allottees; and (iii) a copy of the resolution authorising the issue of such shares [Sec. 75(1) (c)(i)].

15) To make necessary entries in the Register of Members.

16) To prepare and issue new share certificates.

SEBI (i.e., Securities and Exchange Board of India) Guidelines for Issue of Bonus Shares:

The company shall, while issuing bonus shares ensure the following:

a) The bonus issue is made out of free reserves built out of the genuine profits or securities premium collected in cash only.

b) Reserves created by revaluation of fixed assets are not capitalized.

c) The declaration of bonus issue, in lieu of dividend, is not made.

d) The bonus issue is not made unless the partly paid shares, if any are made fully paid-up,

e) The company has not defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption thereof and has sufficient reason to believe that it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity, bonus etc.

f) A Company which announces its bonus issue after the approval of the Board of Directors must implement the proposal within a period of six months from the date of such approval and shall not have the option of changing the decision.

g) There should be a provision in the Articles of Association of the company for capitalization of reserves, and if not, the company shall pass a resolution at its general body meeting making provisions in the Articles of Association for capitalization.

h) Consequent to the issue of bonus shares if the subscribed and paid-up capital exceeds the authorized share capital, a resolution shall be passed by the company at its general body meeting for increasing the authorized capital.

i) The company shall get a resolution passed at its general body meeting for bonus issue and in the said resolution the management’s intention regarding the rate of dividend to be declared in the year immediately after the bonus issue should be indicated.

j) No bonus issue will be made which will dilute the value of rights of the holders of debentures, convertible fully or partly.

Advantages of Issue of Bonus Shares:

(A) For Shareholders:

(1) Immediately Realizable

Bonus shares can be sold in the market immediately after a shareholder gets it.

(2) Not taxable

Bonus shares are not taxable.

(3) Increase in future Income

Shareholders will get dividends on more shares than earlier in future.

(4) Good Image increases the value in market

Bonus shares create a very good image of the company and the shares. Thereby it results in an increase in the value of the share in the market.

(B) For Company:

(1) Economical

It is an inexpensive mode of raising capital by which cash resources of company can be used for some other expansion project.

(2) Wider Marketability

When bonus shares are issued, the market price of shares is automatically reduced which increases its wider marketability?

(3) Increase in Credit Worthiness

Issuing bonus shares means capitalisation of profits and capitalisation of profits always increases the credit worthiness of the company to borrow funds.

(4) More realistic Balance Sheet

The Balance Sheet of the company will reveal a more realistic picture after the issue of bonus shares.

(5) More Capital Availability

After issuing bonus shares, more capital will be available and hence more capital can be utilised for more expansion works.

(6) Unaltered Liquidity Position

Liquidity cash position of the company will remain unaltered with the issue of bonus shares because issue of bonus shares does not result in inflow or outflow of cash.

Disadvantages of Issue of Bonus Shares:

1) Rate of dividend decline

The rate of dividend in future will decline sharply, which may create confusion in the minds of the investors.

2) Speculative dealing

It will encourage speculative dealings in the company’s shares.

3) Forgoes Cash equivalent

When partly paid up shares are converted into fully paid-up shares, the company forgoes cash equivalent to the amount of bonus so applied for this purpose.

4) Lengthy Procedure

Prior approval of the central government through SEBI must be obtained before the bonus share issue. The lengthy procedure, sometime may delay the issue of bonus shares.

Formulating Optimal Dividend Policy

Formulating optimal dividend policy is summarized below:

Share values are influenced by dividend policy decisions. A finance manager should, therefore, endeavour to formulate such dividend policy as may optimise the price of the stock in the market.

The split between retention and dividend should be such as to attract potential investors and raise the market price to the highest attainable level. Such a policy should be formulated keeping in mind investment opportunities of the company, its present financial position and investors’ preferences.

The basic feature of the optimal dividend policy is stability of dividend amount over a long period of time, regardless of fluctuations in level of earnings of the company. Companies pursuing optimal dividend policy maintain a consistent payout ratio, increasing dividends only when it is believed that earnings can sustain them.

Payment of a regular dividend plus intermittent extra dividends permit a company to maintain a record of stable dividends while paying additional dividend when earnings are extraordinarily high.

Stockholders have preference for current dividend income against capital gains because of their desire to earn income presently to satisfy their requirements and to minimize uncertainty in future returns. They are averse to liquidating a portion of their stock-holding for income purposes because of the costs involved in sale of small portions of stocks.

There may be certain stockholders particularly in the high tax bracket who seek capital gains and not current income obviously to reduce their tax liability.

Thus, stockholders’ preferences for dividend or capital gains should be determined after examining the combined influence of the desire for current income, transaction costs and differential tax rate.

If stockholders of a company have innate desire for growth and capital gains, optimal dividend policy of the company should be of residual nature. In such a situation a dividend decision is conditioned exclusively by profitability or investment opportunities of the company.

Thus, after financing all investment projects that promise higher return than what they cost if any surplus is left the same should be distributed to stockholders. Where investment opportunities abound and funds requirements for exploiting these opportunities are more than the current income, there should be no dividend payments.

Where a company has a number of highly profitable investment projects which require funds exactly equal to its earnings and stockholders have desire for dividends as opposed to capital gains, a finance manager in such a situation must balance this net preference against differential costs between financing with new stock and with retained earnings, the difference being attributable to floatation costs and underpricing.

In case net preference for current income is insufficient to cover the differential cost, optimal dividend policy dictates that no dividend should be paid and if net preference covers the costs, the management should go in for dividends.

On the contrary, if the company does not have sufficient profitable projects to consume its entire earnings and if the stockholders have a strong desire for dividends, the management should distribute the unutilised portion of the earnings as dividends.

It may also be worthwhile to examine if dividends in excess of unutilised earnings could be paid out to the stockholders. The analysis should be based on matching net preference for current income against the costs associated with new stock financing.

In case the differential cost is offset by the net preference, optimal dividend policy will be to distribute more the earnings lying unutilised and the excess may come either from retained earnings or from sale of new stock or from both.

Dividend Policy – Top 5 Benefits of Dividend Payment

The dividend of payment or non-payment of dividend has direct influence on the market price of shares. The dividend decision aims at maximizing the wealth of shareholders.

A company can get the following benefits from payment of dividend:

1. To meet investors present preference for dividend.

2. To improve the market price of shares.

3. To improve the image of the company in the market.

4. To attract prospective investors.

5. Concept of time value of money.

Dividend Policy – Stability of Dividend: Meaning, Significance, Forms and Advantages (With Figures)

Meaning of stability of dividend:

Dividends are said to be stable if the company pays a steady dividend to its shareholders every year. The company follows a regular payout policy if it pays a dividend at a fixed rate, and maintains it for a long time even when the profit fluctuates.

When a company follows a stable dividend policy, it is possible that:

(a) Dividends rise even in periods when earnings of the company decline.

(b) Dividends do not rise at the same rate as earnings in the booming years.

This is because the company maintains reserves in the years of prosperity and uses them in paying dividends in lean years. Hence, any volatility in the earnings is not reflected in the payouts. The approximate level of the dividend payout is determined by looking at a forecast of the company’s long-term earnings.

This approach aligns the dividend growth rate of the company with its long-run earnings growth rate. A firm that follows a stable dividend policy can satisfy the shareholders and can enhance the credit in the market. Stability or regularity of dividends is considered a desirable policy by the management of most companies.

Shareholders also generally prefer this policy and prefer stable dividends over the fluctuating ones. Other things being constant, stable dividends have a positive impact on the market price of the share.

Significance of Stability of Dividends:

Stability of dividends is beneficial both for the shareholders and the company.

Followings are its main merits:

(1) Investor’s Desire for Current Income:

Certain investors are such who want to get regular income, For example- superannuated and aged people, women and children. They invest in the shares to meet their living expenses out of dividends income.

If a company declares less dividend, they may have to sell their shares against their desire to do so because they have to incur expenses on brokerage, etc. and also suffer inconvenience. Stable dividend provides them relief and saves from such expenses.

(2) Resolution of Investors’ Uncertainty:

Dividend and change in dividend act as information about the profitability of the firm. When a firm follows a stable dividend policy, it will not change the rate of dividend despite a change in its income. Thus, when the income of a company declines but it pays the dividend which is the same as given in previous years, it gives an indication that the future of the company is bright.

The dividend is increased only when the increased rate can be maintained. If the company changes the rate of dividend with change in its earnings, there will be uncertainty in the minds of investors regarding dividend, and consequently causing a fall in the price of shares.

(3) Institutional Investors’ Requirements:

The shares of companies are not only purchased by individuals but also by institutional investors like IFCI, IDBI, LIC, GIC, UTI, etc.

They purchase the shares in bulk quantities and, thereby, affect the market price of these shares. These investors invest in the shares of those companies who maintain stable dividend policy.

Thus, the companies with stable dividend policy are benefited from investment by institutional investors in their shares which increases the goodwill of the firm in the market. Companies which make frequent changes in their dividend policies are not preferred by these institutions. Thus, stable dividend policy encourages these institutions.

(4) Raising Additional Finances:

A stable dividend policy is beneficial to the company. By following such a policy, company can get external finances conveniently. Investors want to make long-term investment in such a firm. Stable dividend policy increases their faith in the company. When the company issues new shares, such investors will try to purchase them.

Such companies can also issue preference shares or debentures because the public knows that the company has a stable dividend policy.

(5) Routinizing of Dividend Decisions:

By following stable dividend policy, the board of directors need not discuss the level of dividend time and again. Thus, the board can discuss other important matters.

The stability of the dividends may take any of the three distinct forms:

(a) Constant Dividend per Share:

According to this policy, dividends in rupee terms mostly remain constant irrespective of the level of earnings, that is, a fixed amount per share as dividend every year. Most of the times, it is gradually increased over a period.

The following figure shows the profile of dividend payout according to this policy:

The figure shows earnings are fluctuating but have an upward slope. However, dividends do not fluctuate with earnings. When the company expects to maintain new levels of earnings, the annual dividend per share is increased.

The dividend policy of paying a constant amount of dividend per year treats common shareholders somewhat like preference shareholders without giving any consideration to investment opportunities within the firm. This policy is generally preferred by those investors that depend upon the dividend income to meet their living and operating expenses. Most of the business firms use this policy.

(b) Constant Dividend Payout Ratio:

Some companies follow a policy of constant payout ratio that is, paying a fixed percentage of net earnings every year. The dividend paid in this policy varies directly with the earnings. If a company adopts a 30% payout ratio and if earning per share is Rs.100, then a shareholder having 10 shares will receive Rs.300 as dividend under this policy.

The following figure shows the profile of dividend payout according to this policy:

The figure shows that the movement in dividends is exactly similar to the earnings of the company albeit at a lower level.

As dividends are directly proportionate to earnings, this ensures that a part of total earnings are retained for financing future investments. It also prevents the management from overpayment as well as underpayment of dividends.

(c) Constant Dividend per Share plus Extra Dividend:

Under this policy, the management commits to pay a minimum rate of dividend per share. In the years of prosperity, an additional dividend is paid over and above the regular dividend. The extra dividend is paid only if the earnings of the company are higher than the usual. Such a policy is most suitable to the firm having fluctuating earnings from year to year.

This type of a policy enables a company to pay a constant amount of dividend regularly without a default and supplements the income of shareholders only when the company’s profits exceed the normal level.

Of the three forms of stability of dividends, generally a stable dividend policy refers to the first form of paying constant dividend per share.

Advantages of Stability of Dividends:

The stable dividend policy is a popular policy followed by the companies.

It is also the most preferred policy by a common investor due to the following advantages:

(i) Confidence among Shareholders:

When a company pays a regular and stable dividend, it instills confidence among the shareholders. A stable dividend reassures investors of the company’s future when the company maintains the rate of dividends even if its profits are lower. Stable dividends are signs of stable earnings of the company while varying dividends lead to uncertainty in the mind of shareholders.

(ii) Investor’s Preference for Regular Income:

Many investors are income conscious and favour a stable rate of dividend. They consider dividends as a part of regular income to meet their operating expenses. They feel more satisfied and secure if the dividends do not fluctuate over time.

(iii) Requirement of Institutional Investors:

The financial institutions like IDBI, LIC and UTI generally invest in the shares of those companies which have a record of paying regular dividends. A stable dividend policy is an important criteria for an institutional investor for deciding on an investment in a particular firm.

(iv) Gives a Positive Signal:

The dividend policy of firms conveys a lot to the investors. Increasing dividends mean better prospects of the company. On the contrary, decreasing dividends is perceived as poor performance. A stable dividend policy tends to bring stability in the market prices of the shares and increases goodwill of shareholders. It is easier for such companies to raise external finance.

Once a stable dividend policy is adopted, it cannot be changed without seriously affecting investors’ attitude and the financial standing of the company. It is important that the management carefully decides the amount or rate of dividend under stable dividend policy so that it is possible to maintain it even during lean periods.

Stable Dividend Policy – Meaning, Forms, Merits and Significance

Meaning stable dividend policy or stability of dividends:

The term ‘stability of dividends’ refers to the consistency or lack of variability in the stream of dividend payments. It means that a certain minimum amount of dividend is paid out each year. Such a policy is considered a desirable policy by the management of most companies in practice. Shareholders also seem generally to favour the stable dividends more than the fluctuating ones.

The stability of dividends can take any of the following three forms:

(1) Constant (Steady) Dividend per Share:

According to this policy, companies pay a fixed dividend per share every year. For instance, a company may pay a fixed amount of, say Rs.2.50 as dividend on a share having a face value of Rs.10. This amount would be paid each year, irrespective of the fluctuations in the earnings. In fact, the company will pay such a dividend even in those years in which it suffers losses. However, this policy does not imply that the amount of dividend is fixed for all times to come. The dividends are increased when the company reaches new levels of earnings and it is expected that the new levels will be maintained in future also.

The policy of constant dividend per share is most suitable to companies whose earnings are expected to remain stable over a number of years.

(2) Constant / Stable Dividend Payout (D/P) Ratio:

It is another form of stable dividend policy. Under this policy, a firm pays a constant percentage of net earnings as dividend to its shareholders. As a result, the amount of dividend will fluctuate proportionately with earnings.

For instance, if a company adopts a 30% payout ratio, it means that out of every one rupee earned by it, it will distribute 30 paise among its shareholders. If the earning per share (EPS) is Rs.10, it will pay dividend at the rate of Rs.3 per share and if the company incurs loss, no dividend shall be paid.

(3) Constant Dividend Per Share plus Extra Dividend:

Under this policy, the firm pays a fixed dividend per share to its shareholders and in the years of high earnings, an extra dividend is paid over and above the regular dividend. This type of policy is pursued by the companies whose earnings fluctuate widely.

Out of the three policies of stable dividend discussed above, investors usually prefer the first form of paying constant dividend per share. Shares of such a firm command a higher market price as compared to a firm whose dividend varies with fluctuation in earnings.

A stable dividend policy is advantageous to the shareholders as well as the company.

Merits of stable dividend policy:

(i) Fulfilment of Investor’s Desire for Current Income:

There are many investors, such as retired persons, windows etc. who desire to receive regular income to meet their current living expenses. If a company declares a lower dividend, they may have to sell their shares to obtain funds to meet their current expenses. Hence they are willing to pay a higher price for the shares of a company with stable dividends to the one with fluctuating dividends.

(ii) Resolution of Investor’s Uncertainty:

When a firm follows a policy of stable dividends, it will not change the rate of dividend even if there is a change in its earnings. Hence, when its earnings fall and it pays the same rate of dividend as in the past, it gives an indication to the investors that the future of the company is brighter than suggested by the fall in earnings and the value of its shares remains stable.

On the other hand, if a company reduces the dividends with a fall in earnings, there would be uncertainty in the mind of its investors and the share price will fall.

(iii) Requirements of Institutional Investor’s:

A significant factor encouraging stable dividend policy is the requirement of institutional investors like IFCI, IDBI, LIC, GIC, UTI etc. These institutions purchase the shares in large quantities and thereby affect the market price of shares purchased by them.

They purchase the shares of only those companies which have a record of paying continuous and stable dividends. Hence, companies prefer to follow a stable dividend policy to fulfil the requirements of these institutions.

(iv) Raising Additional Finances:

Adoption of stable dividend policy is advantageous to the company in raising funds from external sources. Investors usually purchase shares of those companies which have an uninterrupted record of paying fixed dividends.

Stable dividend policy is also helpful in issuing the debentures and preference shares because the payment of regular dividends is a sufficient assurance to the purchasers of these securities that the company will not make a default in the payment of interest or preference dividend and in returning the principal amount.

(v) Helpful in Long-Term Financial Planning:

Companies following stable dividend policy can easily formulate long-term financial planning because they can correctly estimate the requirement of funds to pay the dividends.

Significance of Stability of Dividend:

Form the stability of dividend, both the shareholders and the company secure certain advantages.

They are as follows:

a. Confidence among Shareholders:

Payment of a regular and stable dividend may help in building confidence in the minds of investors regarding regularity of dividend. When a company follows a policy of stable dividends. It will not change the amount of dividend, if earnings change temporarily.

Thus, when the earnings drop, the company does not cut its dividends. By this the company conveys to investors that the future of the company is brighter than suggested by drop in earnings.

Similarly, the amount of dividend is increased with increased earnings level only if the company is convinced that it is possible to maintain it in future. On the other hand, if a company follows a policy of changing dividend with changes in its earnings, the shareholders not only would not be certain about the amount of dividend but also may entertain doubts about the company’s future.

b. Investors Desire for Current Income:

There are many investors such as women, old and retired persons, etc., who prefer to receive income regularly to meet their living expenses. Such income conscious investors will certainly prefer a company with stable dividends to one with unstable dividends.

c. Institutional Investor’s Requirements:

Investments are made in company shares not only by individuals but also by financial, educational and social institutions and unit trust. Generally, companies are interested to have institutions in the list of their investors.

Normally, the institutions prefer to invest in the shares of those companies which pay dividends regularly. Thus, to attract institutional investors a company prefers to follow a stable dividend policy.

d. Stability in Market Price of Shares:

Stable dividends help in maintaining stability in market price of shares and this is good for both to the company and to the shareholders. Studies of individual shares have revealed that stable dividends buffer the market price of the stock when earnings turn down.

e. Raising Additional Finances:

A stable dividend policy is also advantageous to companies in raising external finance. Stable and regular dividend policy tends to make the shares of a company and investment rather than a speculation.

Investors who purchase these shares tend to hold them for long periods of time and their loyalty and goodwill towards the company increase. If the company issues new shares, they would be more receptive to the offer. Thus, raising additional finance becomes easy for the company.

f. Spreading of Ownership of Outstanding Shares:

Stable dividend policy helps in spreading ownership of outstanding shares more widely among small investors because the persons with small means, in the hope of supplementing their income, usually prefer to purchase shares of those companies which follow stable dividend policy.

g. Reduces the Chances of Loss of Control:

Because of the spreading of ownership of outstanding shares among the large number of small investors, the chances of loss of control by the present management over the company reduced.

h. Market for Debentures and Preference Shares:

A stable dividend policy also helps the sale of debentures and preference shares of the company. The fact that the company has been paying dividend regularly in the past is sufficient assurance to the investors in debentures bonds, and preference shares about their regular income. Hence, a good market is provided for debenture and preference shares.

Thus, the stability of dividends affect the standing and value of equity share and also standing-of the corporation in the eyes of the investing public. This enhanced standing is reflected in the price of the company’s securities.

Dividend Policy – 5 Main Importance of Stable Dividend Policy: It Meets Investors’ Needs for Current Income, Stability of Dividends Resolves Investors’ Uncertainty and More…

Companies try to maintain a stable dividend policy due to the following importance attached to it:

Importance # i. It Meets Investors’ Needs for Current Income:

There is a class of investors which always prefer dividends over capital gains. Stable dividends act as current income for them like wages and salaries. These investors include retired, elderly people, widows, etc. For such investors, the expenses remain more or less constant over a time frame.

Thus, they prefer that the dividend stream should match their expense stream also. In case dividends are unstable, they will not be able to meet their current requirements and will be forced to sell some shares which is inconvenient and also may adversely affect share price of the company.

Importance # ii. Stability of Dividends Resolves Investors’ Uncertainty:

Dividend decision conveys a good amount of information in the minds of investors. An increase in dividend payment signifies an optimistic picture of the firm’s financial position whereas a decrease in dividends may be perceived as a downfall in the future earnings prospects. An erratic dividend policy does not give any information about the company; rather investors feel that the company’s future is not bright enough.

This kind of policy has a negative impact on the market price of a company’s share. Firms should ideally vary dividends gradually when they expect changes in long term prospects.

Importance # iii. Informational Content of Dividends:

It is argued that dividends contain important signals or information about a company’s performance and future prospects. This informational content is lost if the dividend amount varies significantly year after year.

For example- an increase in dividend per share of a company which has been maintaining a stable dividend per share conveys a good signal or positive information about the company’s performance and future prospects.

On the other hand, a decrease in dividend per share of a company which has been maintaining a stable dividend per share conveys a bad signal or negative information about the company’s performance and future prospects. However, a change in dividend per share of a company which has been following a fluctuating dividend policy does not convey any such information.

Importance # iv. Raising Additional Finances:

Stability of dividends also helps in raising additional funds through equity shares. This is because it has provided assurance and confidence to the investors community as they believe that investment in such a company will not result in speculation rather will prove a quality investment.

Importance # v. Requirements of Institutional Investors:

Institutional investors prefer to invest in companies which have a track record of paying stable dividends. Such investors include financial institutions (LIC, IDBI, UTI, etc.), educational and social institutions. Therefore, a stable dividend policy is followed by firms to get funds and satisfy the needs of institutional investors.

Dividend Policy – Corporate Dividend Practice in India: Payout Ratio and Stability of Dividends

Dividend policy is one of the important policies of management of a corporate entity. It indicates the performance of the firm to the investors, lenders, bankers and to the society in general. It is the yardstick through which market value of the shares is measured.

It is highly sensitive to the behaviour of the investors in investing their savings. It is in this context Indian corporations widely use the following two methods in declaring the dividends. They are payout ratio and stability in dividends.

a. Payout Ratio:

Dividend pay ratio refers to the percentage of ratio of dividend to the earnings. This would be decided on the basis of policy of retained earnings. In other words, how much the company has to keep aside from their earnings to meet their future funds requirement and how much should be declared as dividend to the investors. Here the decisions of dividend and the retained earnings are directly related to the earnings of the company.

If a company adopts a policy of declaring the dividend of 30 per cent of net earnings, for every Rs.100 of net earnings Rs.30 will be given in the form of dividend, the remaining amount will be utilised for the purpose retained earnings. Such dividends are received in the form of cash.

The decision of payout ratio will be made by considering the following factors, viz., shareholders preference, cost of equity and cost of retained earnings (floatation), preference to retain the control, liquidity position of the company and access to capital market, etc.

b. Stability of Dividends:

Stability of dividends refers to regularity in paying some dividend annually, even though the earnings of the company fluctuates widely. The decision of stable dividend to equity shareholders will be given to maintain consistency in the market value of the share.

The stability in dividends can be maintained in any one of the following means, viz.:

(i) Constant dividend per share.

(ii) Constant payout ratio.

(iii) Constant dividend plus extra dividend.

Stability of dividends or stable dividend policy is widely used practice in India. Because it suits the requirement of all types of investors, viz., old women and income-oriented investors. The response to such companies from these investors will be good, because of the confidence they assure by declaring or maintaining consistency in dividend.

This would be used as a communication tool to convey the message of performance of a corporate. However, to declare cash dividend, a company has to maintain a high liquidity position and have sufficient cash reserves.

Dividend Policy – Informational Contents of the Dividend: Meaning and Principles

Meaning:

During the perfect competition regime, it can be easily maintained that a firm’s value is purely a function of its investment and financing decisions. Any change in the dividend policy will have no impact on the share price of the company. But the practical situation is quite different. Markets are imperfect i.e. there are transaction cost and floatation costs.

The information communicated to the investors or derived by them through a dividend decision is known as information contents of the dividend. An unexpected change in dividend may have a significant impact on the share price. Generally, investors view change in dividend policy as a signal about the firm’s financial condition or its earning position.

Basically there are two principles:

1. When investors are surprised by the change in dividend policy then price of the share- also gets affected. However, when investors are expecting change in the dividend policy, the price of the share generally gets adjusted even before the formal announcement of dividend policy by the company.

2. Relationship between change in the dividend policy and the share price change is not constant or fixed. Sometimes a decline in the payout ratio may even increase the price of the share.

If a company has reduced the payout amount to finance some profitable investment projects then this may even result in an increase in the share price of the company. This may be because the investors expect an increase in future earnings of the company due to this investment. They can discount future earnings now and can place a higher value to the share of the company.

If the shareholders foresee a permanent increase in payout ratio, the market price of the share will increase. But if they think that the change in dividend policy is temporary, it will not affect the market price of the share. In case, the company’s dividend payment is erratic then it will not provide any informational content.

When the company wants to declare dividends, investors start guessing about this dividend. These guesses are generally based on past trends, current income, government policy etc. The actual dividend is then compared with the expected one.

If the actual dividend turns out to be higher than the expected, then it will give an informational content that future earnings of the company are going to increase. Therefore, when an unexpected change in the dividend policy develops, investors may attach informational content to the event.

Dividend Policy – Interdependence of Dividend, Investment and Financing Decisions (With Courses and Options)

Interdependence of dividend, investment and financing decisions is summarized below:

The dividend payout ratio determines the amount of earnings that can be retained, to be ploughed back as reinvestment in the firm or can be used for other purposes, such as retirement of debt etc.

The determination of dividend payout ratio i.e. percentage of profits to be distributed to shareholders is referred to as dividend decision or dividend policy. It depends upon the existence of profitable investment opportunities available to a firm.

The firm may adopt any of the following courses:

1. The firm may declare low dividends and can retain most of its earnings to be ploughed back as reinvestment. Here retained earnings will constitute an important source of financing.

2. The firm may use retained earnings to retire costly debts hence changing its overall cost of capital and debts-equity ratio in the capital structure.

3. With more retained earnings, the firm can buy back its equity shares. The number of outstanding shares falls, resulting in increasing the EPS and market value of the shares of the firm.

4. The firm may decide to increase the rate of dividend and at the same time want to pursue its growth policy then the firm has to raise additional funds from the market for investment purposes. This may change the debt-equity ratio of the firm. This involves investment and financing decisions.

The above discussion shows that there exists a complete interdependence of investment, financing and dividend decisions. This can also be explained with the help of the following example.

For example, firm ‘A’ has a new investment project, having positive net present value requiring a total investment of Rs. 100 lakhs. The optimum debt/equity ratio is assumed to be 40%. The firm had earned Rs. 140 lakhs last year and has paid dividend at the rate of 60% of earnings.

There are four options to the above:

Option I – The firm can raise Rs. 100 lakhs through external financing, without reducing the dividend amount and keeping the debt/equity ratio at 40%.

Option II – The firm may forego some of its investment opportunities, without reducing the dividend amount and keeping the debt/equity ratio at 40%.

Option III – The firm can increase its debt ratio and thereby maintain the dividend amount.

Option IV – The firm can reduce the dividend amount and maintain the debt/equity ratio.

Let us discuss the above options in detail. In case of option I, financing the investment project externally will involve the cost of raising funds. Funds can be raised through debt and equity.

Funds can be raised through the issue of debt up to a certain level i.e. 40% and the rest amount can be raised through the issue of shares which is a costly affair. Therefore, option I should not be used by the company as it will not add to the wealth of the shareholders due to the high cost of raising funds for investment.

Option II, should not be used in any case as foregoing profitable investment is a bad choice. When a firm passes up an investment opportunity having a net present value, shareholders loose an opportunity to maximise their wealth. It is an opportunity loss to the firm since such an investment increases the wealth of the shareholders.

Option III, is regarding increasing the existing and optimum (assumed) debt/equity ratio. Moving away from the optimum debt/equity ratio will not be a good choice. Therefore, it should not be taken up.

Option IV, is reducing the payout ratio. The firm can generate the funds internally by reducing the payout ratio and use these funds for reinvestment in the new profitable projects. These profitable projects will give returns in the long run and shareholders will gain through capital gains.

But again this decision will depend on the preference of the shareholders for current income or capital gain. Thus, by analysing the above four options, we can conclude that investment, financing and dividend decisions are interrelated. Hence, a particular decision cannot be taken in isolation and its impact on others has to be analysed.

Dividend Policy – Payment of Dividends and Dividend Distribution Procedure

Payment of Dividends:

Most companies that pay dividends pay them quarterly. If the regular quarterly dividend is Rs.4.00, a corresponding regular annual dividend could be Rs.16.00. Annual reports of corporations may often express the pride the firm takes in having maintained a stable dividend over several decades. This article will review the mechanics of the dividend paying procedure.

Dividend Distribution Procedure:

The procedure for declaring and paying a dividend starts with a meeting of the board of directors. For example, at a meeting on August 16, the directors could declare a Rs.4.00 quarterly dividend to all holders of record on September 15, with the payment to be made on October 3. September 15 is then the holder-of- record date, on which the corporation closes its stock transfer books and makes a complete list of all stockholders as of that date.

If notification is given to the company of a transfer of title of the stock before September 15, the new owner will receive the dividend, however, if notification is on or after September 15, the old shareholder receives it.

To guarantee the dividend to a person purchasing the stock before September 15, the brokerage industry has established a policy that the right of the dividend remains with the stock until four days prior to the holder-of-record date. At that time, rights to the dividend no longer go with the shares of stock. This procedure is used to allow ample time to notify the company of the transfer of the stock.

The date that the right to the dividend is eliminated is called the ex-dividend date, and this stock is said to be traded ex-dividend. Thus, a person who purchases the stock prior to September 11 will receive the dividend, if the stock is purchased on September 11 or later, the seller and not the buyer will receive the dividend. On October 3, the payment date, the corporation will mail all dividend checks to the shareholders of record.

Difference between Cash Dividend and Stock Dividend

The difference between cash dividend and stock dividend are as follows:

Difference # Cash Dividends

1. Nature of reward

In this case , the shareholders are rewarded through monetary payments, directly in form of cash.

2. Impact on liquidity of company

The cash held in the form of retained earnings gets transferred to the shareholders and the liquidity of the company is affected.

3. Impact on share capital

It does not result in increase of share capital of the company.

4. Dilution in earning per share

Since there is no increase in number of shares, there is no dilution in the earning per share of a company.

5. Tax on company

The company is required to pay dividend distribution tax at the time of payment of dividend.

6. Tax on Shareholders

The shareholders are not required to pay any tax on the dividend received from domestic companies.

7. Market value of company

The market value of the company decreases by the amount of dividend distributed to the shareholder.

Difference # Stock Dividends

1. Nature of reward

In this cash, the shareholders are rewarded through issue of additional shares , known as bonus shares, free of cost.

2. Impact on liquidity of company

Since there is no cash payment, the liquidity is not affected.

3. Impact on share capital

It increases the share capital of the company due to conversion of reserve and surplus into share capital.

4. Dilution in earning per share

In this case, there is an increase in the number of shares so there is dilution in the earning per share of a company.

5. Tax on company

The company is not required to pay any tax at the time of issue of bonus shares.

6. Tax on Shareholders

The shareholders are subject to capital gain tax (either short term or long term) when these shares are sold by them.

7. Market value of company

The market value remain same even after allotment of stock dividend (bonus shares).

Guidelines on Issuing Bonus Shares

The proposal for issue of bonus shares are examined by the controller of capital issue on the basis of the following guidelines:

1) There should be a provision in the articles of association of the company for the issue of bonus shares.

2) The bonus issue is permitted to be made out of free reserves built out of the genuine profits or share premium collected in cash only.

3) Reserves created by revaluation of fixed assets are not permitted to be capitalised.

4) Development rebate reserve / investment allowance reserve is considered as free reserve for the purpose of calculation of residual reserve test.

5) All contingent liabilities disclosed in the audited accounts which have a bearing on the net profits, shall be taken into account in the calculation of the minimum residual reserves.

6) The residual reserves after the proposed capitalisation should be at least 40 percent of the increased paid up capital.

7) 30 percent of the average profits before tax of the company for the previous three years should yield a rate of dividend on the expanded capital base of the company at 10 percent.

8) Declaration of bonus issue in lieu of dividend is not allowed.

9) The company may make a further application for issue of bonus shares only after 36 months from the date of sanction by the Government of an earlier bonus issue, if any.

10) Bonus issues are not permitted unless the partly paid shares if any existing are made fully paid up.

11) No bonus issue will be permitted if there is sufficient reason to believe that the company has defaulted in respect of the payment of statutory dues of the employees such as contribution of provident fund, gratuity, bonus etc.

12) After the issue of bonus shares the balance in the free reserve should be at least 40 percent of the increased paid up capital.

13) At any one time the total amount permitted to be capitalised for issue of bonus shares out of free reserves, shall not exceed the total amount of paid up equity capital of the company.

14) Applications for issue of bonus shares should be made within one month of the bonus announcement, by the board of directions of the company.

15) If there is a composite proposal for the issue of bonus shares and right shares, the bonus shares will be sanctioned first and the right shares only sometime after.

16) In case, there has been a default in making payment in respect of any term loan outstanding to any public financial institution, a no objection letter from that institution should be furnished by the company along with the bonus issue application.

Dividend Policy – Considerations: Legal and Contractual Constraints

Other Important Considerations are as follows:

Apart from the factors that are important to determine the dividend policy, there are other considerations that play a crucial role in the designing of dividend policy. The legal and contractual factors have to be taken into account while framing a dividend policy.

The legal rules act as boundaries within which a company can declare dividends. On the other hand, the contractual factors relate to restrictive provisions in a loan agreement. These stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid.

1. Legal Constraints:

The legal provisions relating to dividends lay down a framework within which dividend policy is formulated. The legal provisions are based on the three rules relating to dividend payments.

They are:

(a) Net Profit Rule:

This rule provides that the dividends can only be paid out of profits (present or past). A company can pay cash dividends within the limits of current profits plus accumulated balance of retained earnings.

The company can use profits of the past year if the current year’s profits are not sufficient to maintain stable dividend policy. If there are any losses that are to be carried forward, they should be adjusted from current year’s earnings before declaration of dividends.

(b) Capital Impairment Rule:

Dividend payments cannot exceed the amount shown in the retained earnings account on the balance sheet. This legal restriction, known as the impairment of capital rule, is designed to protect creditors.

In other words, dividends cannot be paid out of capital. In the absence of this rule, a company that is not performing well may sell off of its assets and distribute the proceeds to shareholders. This adversely affects the security of creditors as they have a prior claim over a company’s assets.

(c) Insolvency Rule:

A firm is said to be insolvent in two cases. In a legal sense, it is insolvent if the recorded value of liabilities exceeds the recorded value of assets. In a technical sense, it is insolvent if the firm is unable to pay its creditors as obligations fall due. The payment of a dividend is prohibited if a corporation is insolvent or if the dividend payment will cause insolvency.

The rationale of these rules is to protect the creditors.

The provisions relating to source, declaration, payment and prohibition of dividends are discussed as follows:

(a) Source of Dividends:

Dividend can be paid only out of current profit or past profits after providing for depreciation. It can also be paid out of the money provided by the Central or State Government for payment of dividend in pursuance of guarantee given by that government. Before the declaration of dividend, a company may transfer a portion of the profits to the reserves of the company.

This transfer is not mandatory. The company is free to decide the percentage of such a transfer to the reserve.

If there is any inadequacy or absence of profit in any financial year, company may declare dividend out of the accumulated profits subject to the prescribed rules as given below:

(i) The rate of dividend declared shall not exceed the average of the rates at which dividend was declared by it in three years immediately preceding that year. This shall not apply to a company which has not declared dividend in three preceding financial years.

(ii) The total amount to be drawn from such accumulated profits shall not exceed 10% of the sum of its paid up share capital and free reserves.

(iii) The balance of reserves after such withdrawal shall not fall below 15% of its paid-up share capital.

(iv) The amount so drawn shall first be utilized to set off the losses incurred in the financial year in which dividend is declared.

(v) Thereafter, the loss or depreciation of the previous years, whichever is less, is set off against the profit of the company for the year for which dividend is declared or paid.

(b) Declaration of Dividend:

The Board of Directors may declare interim dividend during any financial year out of the surplus in the profit and loss account and out of profits of the financial year in which such interim dividend is sought to be declared.

In case the company has incurred loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, such interim dividend shall not be declared at a rate higher than the average dividends declared by the company during the immediately preceding three financial years. This restriction ensures financial prudence.

(c) Payment of Dividend:

The amount of the dividend, including interim dividend shall be deposited in a scheduled bank in a separate account within 5 days from the date of declaration of such dividend. The dividend shall be paid only to the registered shareholder by cash. It may be paid by cheque or warrant or in any electronic mode to the eligible shareholder.

(d) Prohibition on Dividend:

A company cannot declare dividend if the company fails to comply with Section 73 and Section 74 of Companies Act, 2013 that relates to the acceptance of deposits and repayment of deposits (including interest if any) accepted prior to the commencement of this Act.

2. Contractual Constraints:

Sometimes, the lenders, mostly institutional lenders may put restrictions on the dividend distribution to maintain a certain standard of liquidity and solvency. There is no legal compulsion on the part of a company to distribute dividend. Therefore, the management is bound to honour such restrictions and to limit the distribution of dividend.

There are certain conditions imposed by law in order to protect the interests of the creditors. These conditions pertain to capital impairment, net profits and insolvency that have already been discussed in the preceding section.

The company may accept some important contractual restrictions regarding payment of dividends when the company obtains external funds. The purpose of such contractual restrictions is to protect their interest when the firm is experiencing low liquidity or profitability.

The restrictions may be in three forms:

(a) A certain percentage of profits that can be distributed is fixed.

(b) Maximum amount of profits that can be distributed as dividend is fixed.

The purpose of restricting the cash outflow in the form of dividends is to have sufficient retained earnings that may be reinvested. This reduces the debt-equity ratio thus, increasing the margin of safety for the lenders.

The contractual constraints on dividend payments are quite common. The payment of cash dividend in violation of a restriction would amount to default and entire principal would become due and payable. Keeping in view the severity of penalty, the management should adhere to the covenants already committed to lenders.

The company may postpone the distribution of dividend in cash, which may be conserved for strengthening the financial condition of the company by declaring stock dividend or bonus shares.

The payment of dividend is not a contractual obligation like interest. Therefore, the formulation of dividend policy requires a balanced financial judgment by judiciously weighing a set of different factors affecting the dividend policy.

Dividend Policy – Multiple Choice Questions and Answers

1. _____ is the portion of divisible profits that is distributed to the shareholders

(a) Interest

(b) Dividend

(d) None of these

Ans – (b)

2. Dividends are payable

(a) Monthly

(b) Quarterly

(d) Yearly

Ans – (d)

3. Dividends are paid out of

(a) Accumulated profits

(b) Gross profit

(d) General reserve

Ans – (c)

4. A _____ is a payment of additional shares to shareholders in lieu of cash

(a) Regular dividend

(b) Extra dividend

(d) Stock split

Ans – (c)

5. A stock dividend

(a) Increases the value of shareholders’ equity

(b) Decreases the value of shareholders’ equity

(d) None of these

Ans – (c)

6. A _________ is the expected cash dividend that is normally paid to shareholders

(a) Regular dividend

(b) Extra dividend

(d) Stock split

Ans – (a)

7. _______ is a non-recurring dividend paid to shareholders in addition to the regular dividend

(a) Regular dividend

(b) Extra dividend

(d) Stock split

Ans – (b)

8. _____ dividend promises to pay shareholders at future date

(a) Scrip

(b) Cash

(d) Property

Ans – (a)

9. Which of the following is not relevant for dividend payment for a year?

(a) Cash flow position

(b) Profit position

(d) Retained earnings

Ans – (d)

10. _____ is the proportion of profits kept in, that is reinvested in the business

(a) Long term investment

(b) Short term investment

(d) None of these

Ans – (c)

11. Individuals in a high tax bracket typically prefer for a firm to

(a) Issue dividends

(b) Hold cash

(d) None of these

Ans – (c)

12. The board of directors may do which of the following with net income?

(a) Retain it

(b) Pay it out as dividends

(d) (a) and (b) above

Ans – (d)

13. A _______ occurs when there is an increase in the number of shares outstanding by reducing par value of stock

(a) Regular dividend

(b) Extra dividend

(d) Stock split

Ans – (d)

14. The purpose of stock split is usually to

(a) Reduce the threat of takeover

(b) Decrease the number of shares outstanding

(d) Bring down the stock price into a lower trading range

Ans – (d)

15. The ex- dividend date is a date

(a) The dividend is declared

(b) On which recipients of the dividend are determined

(d) None of these

Ans – (c)

16. Companies with higher growth pattern are likely to

(a) Pay lower dividends

(b) Pay higher dividends

(d) None of the above

Ans – (a)

17. If a preferred stock issue is cumulative, this means

(a) Dividends are paid at the end of the year

(b) Dividends are legally binding on the company

(d) Unpaid dividends are never repaid

Ans – (c)

18. A company having easy access to the capital markets can follow _____ dividend policy

(a) Liberal

(b) Formal

(d) Varying

Ans – (a)

19. Which one of the following terms is defined as dividends paid expressed as a percentage of net income?

(a) Dividend payout ratio

(b) Dividend yield

(d) Dividend portion

Ans – (a)

20. The dividend payout ratio is equal to

(a) The dividend yield plus the capital gains yield

(b) Dividend per share divided by EPS

(d) Dividend per share divided by current price per share

Ans – (b)

21. In retention growth model, percent of net income firms usually payout as shareholders dividend is classified as

(a) Payout ratio

(b) Payback ratio

(d) Present value of ratio

Ans – (a)

22. Which of the following is an argument for the relevance of dividends?

(a) Informational content

(b) Reduction of uncertainty

(d) All of the above

Ans – (d)

23. The rational expectation model of dividend policy says that

(a) Since the expectation of the investors are always rational, there will be no effect of dividend policy on the valuation of the firm

(b) If the investors have rational expectation, they will value a dividend paying firm higher than a non-dividend paying firm

(c) If the declared dividend is in line with expectations of the investors, there will be no effect on the valuation of the firm

(d) If the declared dividend is in accordance with the expectations,. The change in the firms value will be minimal

Ans – (d)

24. The market value of a share of common stock is determined by

(a) the board of directors of the firm

(b) The stock exchange on which the stock is listed

(d) Individuals buying and selling the stock

Ans – (d)

25. According to the______ model, the dividend decision is irrelevant

(a) MM

(b) Gordon

(d) XY

Ans – (a)

26. Which of the following is the assumption of MM model on dividend policy?

(a) The firm is an all equity firm

(b) The investments of the firm are financed solely by retained earnings

(d) None of the above

Ans – (c)

27. Dividend policy of a firm affects both the long term financing and _____ wealth

(a) Owners

(b) Creditors

(d) Shareholders

Ans – (d)

28. The market value of the firm is the result of

(a) Dividend decisions

(b) Working capital decisions

(d) Tradeoff between cost and risk

Ans – (d)

29. Walter model of dividend policy assumes that

(a) The firm offers an increasing amount of dividend per share at a given level of price per share

(b) The firm has s finite life

(d) Equal to current assets plus current liabilities including bank borrowings

Ans – (d)

30. Dividend changes are perceived important than the absolute level of dividends because

(a) Management changes the dividend to protect their seats

(b) Dividend changes are thought to signal future expectations

(d) Changes determines the level of borrowing

Ans – (b)

31. Which of the following methods does a firm resort to avoid dividend payments?

(a) Share splitting

(b) Declaring bonus shares

(d) New issue

Ans – (b)

32. In retention growth model, payout ratio is subtracted from one to calculate

(a) Present value ratio

(b) Future value ratio

(d) Growth ratio

Ans – (c)

33. A sound dividend policy contains the _______ features

(a) Gradually raising dividend rates

(b) Distribution of cash

(d) All of the above

Ans – (d)

34. The dividend payout rate is equal to

(a) Dividends per share by EPS

(b) Dividend yield plus capital gain yield

(d) Dividends per share by current price per share

Ans – (a)

35. Stock split is a form of

(a) Dividend payment

(b) Bonus issue

(d) Dividend in cash

Ans – (c)

36. Which of the following is not a type of dividend payment?

(a) Bonus issue

(b) Rights issue

(d) Both (b) and (c)

Ans – (c)

37. Higher dividend per share is associated with

(a) High earnings, high cash flows, unusable earnings and higher growth opportunities

(b) High earnings, high cash flows, stable earnings and higher growth opportunities

(d) High earnings, low cash flows, stable earnings and lower growth opportunities

Ans – (c)

38. In Walter model formula, D stands for

(a) Dividend per share

(b) Direct dividend

(d) None of these

Ans – (a)

39. What are the different options other than cash used for distributing profits to shareholders?

(a) Bonus shares

(b) Stock split

(d) All of these

Ans – (d)

40. Retention ratio is 0.60 and return on equity is 15.5%, then growth retention model would be

(a) 14.90%

(b) 25.84%

(d) 9.30%

Ans – (d)

41. If payout ratio is 0.45, then retention ratio will be

(a) 0.55

(b) 1.45

(d) 0.45

Ans – (a)

42. Retention ratio is 0.55 and return on equity is 12.5%, then growth retention model would be

(a) 11.95%

(b) 6.88%

(d) 22.72%Ans – (b)

The focus of the dividend decision is on the dividend paid to the equity shareholders, as preference shareholders are entitled to a fixed rate of dividend.

Dividend policy of a company is the strategy followed to decide the amount of dividends and the timing of the payments. There are various factors that frame a dividend policy of the company.

According to Weston and Brigham, “Dividend policy determines the division of earnings between payments to shareholders and retained earnings”.

Contents

Dividend Policy – An Overview
Introduction to Dividend Policy
Meaning of Dividend
Definition of Dividend
Meaning of Dividend Policy
Definition of Dividend Policy
Objectives of Dividend Policy
Factors to be Considered While Framing Dividend Policy in an Organization
Types of Dividends Offered to The Shareholders
Significance of Dividend Policy
Importance of Dividend Decision
Forms of Dividend in a Company
Alternate Forms of Dividend
Informational Contents of the Dividend
Theories of Dividend Policies
Modigliani-Miller’s Model (M-M’s Model)
Factors Affecting the Dividend Division of a Firm
Approaches to Dividend Policy
Approaches to Dividend Decisions
Dividend Payout Ratio
Right Issue of Shares
Cash Dividend
Stock Dividends
Bonus Shares
Formulating Optimal Dividend Policy
Benefits of Dividend Payment in a Company
Stability of Dividend
Stable Dividend Policy
Importance of Stable Dividend Policy in Companies
Corporate Dividend Practice in India
Informational Contents of the Dividend
Interdependence of Dividend, Investment and Financing Decisions
Payment of Dividends and Dividend Distribution Procedure
Difference between Cash Dividend and Stock Dividend
Considerations
Multiple Choice Questions and Answers

What is a Dividend Policy: Meaning, Definition, Objectives, Types, Significance, Forms, Theories, Factors, Approaches, Stable Dividend Policy and More…

Dividend Policy – An Overview

In its decision to pay dividend to its shareholders, a company should, therefore, consider the following points:

(i) The first thing is to consider the relationship between r and k. If r > k, low dividend should be recommended and vice versa if r < k.

Dividend Policy – Introduction

The focus of the dividend decision is on the dividend paid to the equity shareholders, as preference shareholders are entitled to a fixed rate of dividend.

Dividend Policy – Meaning of Dividend

Dividend Policy – Definition of Dividend

A very brief definition is “a dividend is a share of the profits of a company dividend amongst the shareholder”.

Dividend Policy – Meaning

The firms have two options with them:

a. They can retain these profits within the firm.

b. They can pay these profits in the form of dividends to their shareholders.

Dividend Policy – Definitions

Dividend policy of a company is the strategy followed to decide the amount of dividends and the timing of the payments. There are various factors that frame a dividend policy of the company.

The term dividend policy has been defined by some authors as given below:

(i) Weston and Brigham: Dividend policy determines the division of earnings between payments to shareholders and retained earnings.

(ii) Gitman: The firm’s dividend policy represents a plan of action to be followed whenever the dividend decision must be made.

Definition:

According to Weston and Brigham, “Dividend policy determines the division of earnings between payments to shareholders and retained earnings”.

For this purpose a dividend equalisation fund is created out of profits, to equalise the profits of the coming years.

Top 4 Objectives of Dividend Policy

While chalking out dividend policy the following points of objectives must be considered:

(i) Whether the payment of dividend should be made from the initial years of operations (i.e., should there be regular dividend).

(ii) Whether a fixed amount of dividend or fixed percentage of dividend should be given irrespective of the amount (volume) of profit earned (i.e., should there be constant dividend).

(iii) Whether a definite percentage of profit should be given as dividend which means variable dividend per share (i.e., a definite pay-out ratio should be there).

(iv) Whether the dividends be paid in cash or in other forms.

Factors to be Considered While Framing Dividend Policy in an Organization – Fund Requirements, Expectations of Shareholders and Status quo Factor

Before framing dividend policy, the organization should take into consideration the following factors:

Factor # 1. Fund Requirements:

Refer to the availability of funds with the organization so that it can distribute dividends. If the organization does not have sufficient funds then it cannot distribute dividends.

Factor # 2. Expectations of Shareholders:

Factor # 3. Status quo Factor:

According to professor I. M. Pandey, organizations should know the answers of following questions before formulating dividend policy:

i. What are the preferences of shareholders: dividend income or capital gain?

ii. What are the financial needs of the company?

iii. What are the constraints on paying dividends?

iv. Should the company follow a stable dividend policy?

v. What should be the form of dividend (i.e., cash or bonus shares)?

Dividend Policy – Types of Dividends Offered to The Shareholders: Regular, Interim, Stock, Bond and Property Dividend

Following are the different types of dividends offered to the shareholders of the firm:

Type # (i) Regular Dividend:

It is generally paid in cash as a percentage of paid up capital, say 10% or 15% of the capital. Sometimes it is paid per share. No dividend is paid on calls-in-advance or calls-in-arrear.

Type # (ii) Interim Dividend:

Type # (iii) Stock Dividend:

For shareholders, this situation resembles a slice of cake. You can divide the slice into two, three or four pieces and no mallei how many ways you slice it, its overall size remains the same.

After a stock dividend, shareholders receive more shares, but their proportionate ownership interest in the firm remains the same and the market price declines proportionately

Type # (iv) Bond Dividend:

Type # (v) Property Dividend:

But it is however important to note that in India, distribution of dividend is permissible in the form of cash or bonus shares only. Distribution of dividend in any other form is not allowed.

Top 6 Significance of Dividend Policy – Resolves Investors’, Uncertainty, Investors’ Desire for Current Income, Institutional Investors’ Requirement and More…

Significance of dividend policy are as follows:

Significance # 1. Resolves investors’ uncertainty

In case of abnormal profits, the amount of dividend is increased by the company. Thus, the stable dividend policy of the company removes uncertainty of payments in the mind of shareholders.

Significance # 2. Investors’ desire for current income

Significance # 3. Institutional investors’ requirement

Significance # 4. In India, financial institutions

Significance # 5. Raising additional finances

The stable dividend policy is advantageous to the company in raising further funds from the market. The investors preferably invest in securities of a company paying regular dividends.

Significance # 6. Informational contents

Dividend Policy – Importance of Dividend Decision: Investors’ Preference for Dividends, Informational Content of Dividend and More…

Importance of dividend decision are as follows:

i. Investors’ Preference for Dividends:

ii. Informational Content of Dividend (Information Signaling):

Basically, the idea is that management, instead of announcing about the company’s future prospects can increase or decrease dividends depending on the situation and convey important information.

iii. Bird-in-Hand is Better than Two in Bush I.E. Resolution of Uncertainty:

iv. Distribution of Temporary Excess Cash:

Dividend Policy – Forms of Dividend in a Company: Scrip, Bond, Property, Cash and Stock Dividend

Dividend that is being distributed by a company may take several forms, viz.:

(a) Scrip dividend,

(b) Bond dividend,

(d) Cash dividend, and

(e) Stock dividend.

In India, only cash dividends and stock dividends are declared and paid.

We shall give here a brief explanation of these forms of dividend:

Form # (a) Scrip Dividends:

Scrip dividends are justified only when the company has really earned profit and has only to wait for the conversion of other current assets into cash in the course of operations.

Form # (b) Bond Dividends:

Form # (c) Property Dividends:

This involves a payment with assets other than cash. This form of dividend may be followed wherever there are assets that are no longer necessary in the operation of the business.

Form # (d) Cash Dividend:

Cash dividend is the dividend which is distributed to the shareholders in cash out of the earnings of the business.

Form # (e) Stock Dividend (Bonus Shares/Share):

Bonus shares are additional shares given to the shareholders without any additional cost, based upon the number of shares that a shareholder owns.

Dividend Policy – 4 Main Alternate Forms of Dividend: Bonus Shares, Stock Split, Reverse Split and Buy Back

Alternate forms of dividend are as follows:

1. Bonus Shares:

Price after bonus issue = (No. of shares before bonus issue ‘”‘current market price)/No. of shares after bonus issue.

2. Stock Split:

The book value, EPS and market price reduces as in case of bonus issue due to increase in no. of shares. After splitting the shares the shareholder’s fund remain same as before share split.

Price after stock split = (No. of shares before stock split *current market price)/No. of shares after stock split.

3. Reverse Split:

The par value of shares will increase to Rs. 40 per share because four shares with par value of Rs. 10 each will be merged into a single share with par value Rs. 40.

Price after reverses split = (No. of shares before reverses split *current market price)/No. of shares after reverse split.

4. Buy Back:

Second method is an open market purchase method in which the company buys back its shares from the secondary market. The buyback causes reduction in capital of the company and increase in EPS.

Price after buy back = No. of shares before buy back *current market price/No. of shares after buy back.

Dividend Policy – Informational Contents of the Dividend

Informational contents of the dividend are summarized below:

There is a wide gap in respect of availability of true information regarding the internal functioning of a company between the managers (insiders) and the shareholders (outsiders).

Thus, asymmetry exists between the managers of the company and shareholders of the company so far the availability of information is concerned.

In this case, since managers know more about the internal affairs of the company than investors, investors will find “signals” in the managers’ actions to get clues about the firm.

In real life situations, dividend decisions are seen by investors as revealing information about a firm’s prospects therefore firms are very particular about these decisions.

From the above, we can conclude that payment of dividend by a company to its shareholders not only rewards the shareholders but also conveys information about the future prospects of the company.

Theories of Dividend Policies – Tax Differential Theory, Residual Theory, 100% Payout Theory, 100% Retention Theory, Investor Rationality Theory and Span of Control Theory

The important theories of dividend policy are discussed in brief as follows:

Theory # 1. Tax Differential Theory:

Theory # 2. Residual Theory:

Theory # 3. 100% Payout Theory:

Rubner (1966) argued that shareholders prefer dividends and directors requiring additional finance would have to convince investors that proposed new investments offer positive increases in wealth.

Theory # 4. 100% Retention Theory:

They argue further that successful investment opportunities are open to the firm and that there is no point in paying dividends and raising additional capital.

Theory # 5. Investor Rationality Theory:

Theory # 6. Span of Control Theory:

Dividend Policy – Modigliani-Miller’s Model (M-M’s Model): Meaning, Assumptions, Example and Evaluation

Meaning:

Basic Assumptions of M-M Approach:

(2) There does not exist taxes. Alternatively, there is no tax differential between income on dividend and capital gains.

(3) Firm’s investment policy is well planned and is fixed for all the time to come.

(4) There is no uncertainty as to future investments and profits of the firm. Thus, investors are able to predict future prices and dividends with certainty. This assumption is dropped by M-M later.

Suppose, for example, a firm decides to invest in a project it has two alternatives:

(1) Pay out dividends and raise an equal amount of funds from the market;

(2) Retain its entire earnings to finance the investment programme. The arbitrage process is involved where a firm decides to pay dividends and raise funds from outside.

M-M approach contains the following mathematical formulations to prove irrelevance of dividend decision.