Dividend Policy

Dividend Policy Dividend Policy Meaning and Types Meaning and Types

Once a company makes a profitOnce a company makes a profit, they must decide on what , they must decide on what to do with those profits. to do with those profits.

They could continue to retain the profits within the company, orThey could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the they could pay out the profits to the owners of the firm in the

form of dividends. form of dividends. Once the company decides on whether to pay dividends, they Once the company decides on whether to pay dividends, they

may establish a somewhat permanent dividend policy, which may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the may in turn impact on investors and perceptions of the company in the financial markets.company in the financial markets.

What they decide depends on the situation of the company What they decide depends on the situation of the company now and in the future.now and in the future.

It also depends on the preferences of investors and potential It also depends on the preferences of investors and potential investors. investors.

These policies shape the attitude of the investors and the These policies shape the attitude of the investors and the financial marketfinancial market in general towards the concerned company. in general towards the concerned company.

Types of Dividend Policy Types of Dividend Policy (1) Policy of No Immediate Dividend:(1) Policy of No Immediate Dividend: Generally, management follows a policy of paying Generally, management follows a policy of paying

no immediate dividend in the beginning of its life, no immediate dividend in the beginning of its life, as it requires funds for growth and expansion. as it requires funds for growth and expansion.

In case, when the outside funds are costlier or In case, when the outside funds are costlier or when the access to capital market is difficult for when the access to capital market is difficult for the company and shareholders are ready to wait the company and shareholders are ready to wait for dividend for sometime, this policy is justified, for dividend for sometime, this policy is justified, provided the company is growing fast and it provided the company is growing fast and it requires a good deal of amount for expansion.requires a good deal of amount for expansion.

But such a policy is not justified for a long time, But such a policy is not justified for a long time, as the shareholders are deprived of the dividend.as the shareholders are deprived of the dividend.

(2)Regular or Stable Dividend (2)Regular or Stable Dividend Policy:Policy:

When a company pays dividend regularly at a When a company pays dividend regularly at a fixed rate, and maintains it for a considerably fixed rate, and maintains it for a considerably long time even though the profits may fluctuate, long time even though the profits may fluctuate, it is said to follow regular or stable dividend policyit is said to follow regular or stable dividend policy

. Thus stable dividend policy means a policy of . Thus stable dividend policy means a policy of paying a minimum amount of dividend every year paying a minimum amount of dividend every year regularly. regularly.

It raises the prestige of the company in the eyes It raises the prestige of the company in the eyes of the investors. of the investors.

Not only that the dividend must be regularly paid Not only that the dividend must be regularly paid but the dividend must be stable .but the dividend must be stable .

It may be fixed amount per share or a fixed It may be fixed amount per share or a fixed percentage of net profits or it may be total fixed percentage of net profits or it may be total fixed amount of dividend on all the shares etc. amount of dividend on all the shares etc.

(3) Regular Dividend plus Extra (3) Regular Dividend plus Extra Dividend Policy.Dividend Policy.

A firm paying regular dividends would continue A firm paying regular dividends would continue with its pay out ratio.with its pay out ratio.

But when the earnings exceed the normal level, But when the earnings exceed the normal level, the directors would pay extra dividend in addition the directors would pay extra dividend in addition to the regular dividend. to the regular dividend.

But it would be named 'Extra dividend', as it should But it would be named 'Extra dividend', as it should not give an impression that the company has not give an impression that the company has enhanced rate of regular dividend.enhanced rate of regular dividend.

This would give an impression to shareholders that This would give an impression to shareholders that the company has given extra dividend because it the company has given extra dividend because it has earned extra profits and would not be repeated has earned extra profits and would not be repeated when the business earnings become normal. when the business earnings become normal.

This system is not found in India.This system is not found in India.

(4)(4) Irregular Dividend Policy:Irregular Dividend Policy: When the firm does not pay out fixed dividend When the firm does not pay out fixed dividend

regularly, it is irregular dividend policy. regularly, it is irregular dividend policy. It changes from year to year according to It changes from year to year according to

changes in earnings level.changes in earnings level. This policy is based on the management belief This policy is based on the management belief

that dividend should be paid only when the that dividend should be paid only when the earnings and liquid position of the firm warrant earnings and liquid position of the firm warrant it.it.

This policy is followed by firms having This policy is followed by firms having unstable earnings unstable earnings

(5) Regular Stock Dividend (5) Regular Stock Dividend Policy:Policy:

When a firm pays dividend in the When a firm pays dividend in the form of shares instead of cash form of shares instead of cash regularly for some years regularly for some years continuously, it is said to follow this continuously, it is said to follow this policy. policy.

We know stock dividend as bonus We know stock dividend as bonus shares. shares.

(6) Regular Dividend plus Stock (6) Regular Dividend plus Stock Dividend Policy:Dividend Policy:

A firm may pay certain amount of A firm may pay certain amount of dividend in cash and some dividend dividend in cash and some dividend is paid in the form of shares (stock). is paid in the form of shares (stock).

(7) Liberal Dividend Policy:(7) Liberal Dividend Policy: It is a policy of distributing a major It is a policy of distributing a major

part of its earnings to its part of its earnings to its shareholders as dividend and retains shareholders as dividend and retains a minimum amount as retained a minimum amount as retained earnings. earnings.

Factors Affecting Dividend Policy Factors Affecting Dividend Policy A number of considerations affect the dividend A number of considerations affect the dividend

policy of company. The major factors arepolicy of company. The major factors are

1. Stability of Earnings. 1. Stability of Earnings. The nature of business The nature of business has an important bearing on the dividend policy. has an important bearing on the dividend policy. Industrial units having stability of earnings may Industrial units having stability of earnings may formulate a more consistent dividend policy than formulate a more consistent dividend policy than those having an uneven flow of incomes because those having an uneven flow of incomes because they can predict easily their savings and earnings. they can predict easily their savings and earnings.

Usually, enterprises dealing in necessities suffer Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in less from oscillating earnings than those dealing in luxuries or fancy goods. luxuries or fancy goods.

2. Age of corporation.2. Age of corporation. Age of the corporation counts much in Age of the corporation counts much in

deciding the dividend policy.deciding the dividend policy. A newly established company may A newly established company may

require much of its earnings for require much of its earnings for expansion and plant improvement and expansion and plant improvement and may adopt a rigid dividend policy may adopt a rigid dividend policy

while, on the other hand, an older while, on the other hand, an older company can formulate a clear cut and company can formulate a clear cut and more consistent policy regarding more consistent policy regarding dividend. dividend.

3. Liquidity of Funds.3. Liquidity of Funds. Availability of cash and sound financial Availability of cash and sound financial

position is also an important factor in dividend position is also an important factor in dividend decisions. decisions.

A dividend represents a cash outflow, the A dividend represents a cash outflow, the greater the funds and the liquidity of the firm greater the funds and the liquidity of the firm the better the ability to pay dividend. the better the ability to pay dividend.

The liquidity of a firm depends very much on The liquidity of a firm depends very much on the investment and financial decisions of the the investment and financial decisions of the firm which in turn determines the rate of firm which in turn determines the rate of expansion and the manner of financing. expansion and the manner of financing.

If cash position is weak, stock dividend will be If cash position is weak, stock dividend will be distributed and if cash position is good, distributed and if cash position is good, company can distribute the cash dividend company can distribute the cash dividend

4. Extent of share Distribution.4. Extent of share Distribution. Nature of ownership also affects the Nature of ownership also affects the

dividend decisions. dividend decisions. A closely held company is likely to get the A closely held company is likely to get the

assent of the shareholders for the assent of the shareholders for the suspension of dividend or for following a suspension of dividend or for following a conservative dividend policy. conservative dividend policy.

On the other hand, a company having a On the other hand, a company having a good number of shareholders widely good number of shareholders widely distributed and forming low or medium distributed and forming low or medium income group, would face a great difficulty income group, would face a great difficulty in securing such assent because they will in securing such assent because they will emphasise to distribute higher dividend. emphasise to distribute higher dividend.

5. Needs for Additional Capital.5. Needs for Additional Capital. . Companies. Companies retain a part of their profits retain a part of their profits

for strengthening their financial position. for strengthening their financial position. The income may be conserved for meeting The income may be conserved for meeting

the increased requirements of working the increased requirements of working capital or of future expansion. capital or of future expansion.

Small companies usually find difficulties in Small companies usually find difficulties in raising finance for their needs of increased raising finance for their needs of increased working capital for expansion programmes.working capital for expansion programmes.

They having no other alternative, use their They having no other alternative, use their ploughed back profits. Thus, such ploughed back profits. Thus, such Companies distribute dividend at low rates Companies distribute dividend at low rates and retain a big part of profits. and retain a big part of profits.

6. Trade Cycles6. Trade Cycles Business cycles also exercise influence upon Business cycles also exercise influence upon

dividend Policy.dividend Policy. Dividend policy is adjusted according to the Dividend policy is adjusted according to the

business oscillations.business oscillations. During the boom, prudent management creates During the boom, prudent management creates

food reserves for contingencies which follow the food reserves for contingencies which follow the inflationary period. inflationary period.

Higher rates of dividend can be used as a tool for Higher rates of dividend can be used as a tool for marketing the securities in an otherwise marketing the securities in an otherwise depressed market.depressed market.

The financial solvency can be proved and The financial solvency can be proved and maintained by the companies in dull years if the maintained by the companies in dull years if the adequate reserves have been built up. adequate reserves have been built up.

7. Government Policies.7. Government Policies. The earnings capacity of the enterprise is The earnings capacity of the enterprise is

widely affected by the change in fiscal, widely affected by the change in fiscal, industrial, labour, control and other industrial, labour, control and other government policies. government policies.

Sometimes government restricts the Sometimes government restricts the distribution of dividend beyond a certain distribution of dividend beyond a certain percentage in a particular industry or in all percentage in a particular industry or in all spheres of business activity as was done in spheres of business activity as was done in emergency. emergency.

The dividend policy has to be modified or The dividend policy has to be modified or formulated accordingly in those enterprises. formulated accordingly in those enterprises.

8. Taxation Policy.8. Taxation Policy. High taxation reduces the earnings of High taxation reduces the earnings of

he companies and consequently the he companies and consequently the rate of dividend is lowered down.rate of dividend is lowered down.

9. Legal Requirements.9. Legal Requirements. In deciding on the dividend, the directors In deciding on the dividend, the directors

take the legal requirements too into take the legal requirements too into consideration.consideration.

In order to protect the interests of creditors In order to protect the interests of creditors and outsiders, the companies Act 1956 and outsiders, the companies Act 1956 prescribes certain guidelines in respect of the prescribes certain guidelines in respect of the distribution and payment of dividend distribution and payment of dividend

It proposes that Dividend should not be It proposes that Dividend should not be distributed out of capita, in any case.distributed out of capita, in any case.

Likewise, contractual obligation should also Likewise, contractual obligation should also be fulfilled, for example, payment of dividend be fulfilled, for example, payment of dividend on preference shares in priority over ordinary on preference shares in priority over ordinary dividend. dividend.

10. Past dividend Rates.10. Past dividend Rates. While formulating the Dividend Policy, the While formulating the Dividend Policy, the

directors must keep in mind the dividend directors must keep in mind the dividend paid in past years. paid in past years.

The current rate should be around the The current rate should be around the average past rat. If it has been abnormally average past rat. If it has been abnormally increased the shares will be subjected to increased the shares will be subjected to speculation. speculation.

In a new concern, the company should In a new concern, the company should consider the dividend policy of the rival consider the dividend policy of the rival organisation. organisation.

11. Ability to Borrow.11. Ability to Borrow. Well established and large firms have better Well established and large firms have better

access to the capital market than the new access to the capital market than the new Companies and may borrow funds from the Companies and may borrow funds from the external sources if there arises any need. external sources if there arises any need.

Such Companies may have a better dividend Such Companies may have a better dividend pay-out ratio. pay-out ratio.

Whereas smaller firms have to depend on Whereas smaller firms have to depend on their internal sources and therefore they will their internal sources and therefore they will have to built up good reserves by reducing have to built up good reserves by reducing the dividend pay out ratio for meeting any the dividend pay out ratio for meeting any obligation requiring heavy funds. obligation requiring heavy funds.

12. Policy of Control.12. Policy of Control. Policy of control is another determining factor is Policy of control is another determining factor is

so far as dividends are concerned.so far as dividends are concerned. If the directors want to have control on company, If the directors want to have control on company,

they would not like to add new shareholders and they would not like to add new shareholders and therefore, declare a dividend at low rate. therefore, declare a dividend at low rate.

Because by adding new shareholders they fear Because by adding new shareholders they fear dilution of control and diversion of policies and dilution of control and diversion of policies and programmes of the existing management.programmes of the existing management.

So they prefer to meet the needs through So they prefer to meet the needs through retained earing. If the directors do not bother retained earing. If the directors do not bother about the control of affairs they will follow a about the control of affairs they will follow a liberal dividend policy.liberal dividend policy.

Thus control is an influencing factor in framing Thus control is an influencing factor in framing the dividend policy. the dividend policy.

13. Repayments of Loan.13. Repayments of Loan. A company having loan indebtedness are vowed to A company having loan indebtedness are vowed to

a high rate of retention earnings, unless one other a high rate of retention earnings, unless one other arrangements are made for the redemption of debt arrangements are made for the redemption of debt on maturity. on maturity.

It will naturally lower down the rate of dividend. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution lenders) put restrictions on the dividend distribution still such time their loan is outstanding.still such time their loan is outstanding.

Formal loan contracts generally provide a certain Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and Management is bound to hour such restrictions and to limit the rate of dividend payout. to limit the rate of dividend payout.

14. Time for Payment of 14. Time for Payment of Dividend.Dividend.

When should the dividend be paid is another When should the dividend be paid is another consideration. Payment of dividend means consideration. Payment of dividend means outflow of cash.outflow of cash.

It is, therefore, desirable to distribute It is, therefore, desirable to distribute dividend at a time when is least needed by dividend at a time when is least needed by the company because there are peak times the company because there are peak times as well as lean periods of expenditure.as well as lean periods of expenditure.

Wise management should plan the payment Wise management should plan the payment of dividend in such a manner that there is no of dividend in such a manner that there is no cash outflow at a time when the undertaking cash outflow at a time when the undertaking is already in need of urgent finances. is already in need of urgent finances.

15 Attitude of Management 15 Attitude of Management The attitude of management has The attitude of management has

considerable impact on dividend policy. considerable impact on dividend policy. The management with foresight and The management with foresight and

conservative attitude would declare lower conservative attitude would declare lower dividend and major part of the profit would dividend and major part of the profit would be kept in business to strengthen its be kept in business to strengthen its financial position. financial position.

The management with liberal attitude The management with liberal attitude would be liberal in dividend policy. Prudent would be liberal in dividend policy. Prudent management would always adopt a bit management would always adopt a bit conservative dividend policy. conservative dividend policy.

16 Present Amount of Reserves 16 Present Amount of Reserves A company having sufficient amount of reserves A company having sufficient amount of reserves

would be able to face the times of low demand would be able to face the times of low demand with confidence, the prudent management would with confidence, the prudent management would therefore, try to build up, sufficient reserves during therefore, try to build up, sufficient reserves during boom period by restricting the rate of dividend and boom period by restricting the rate of dividend and thus try to strengthen its financial position. thus try to strengthen its financial position.

Of course, in India it has been made compulsory by Of course, in India it has been made compulsory by Companies Act that companies are required to Companies Act that companies are required to transfer not more than 10% of their net profits to transfer not more than 10% of their net profits to Reserve if the rate of dividend exceeds 10% on Reserve if the rate of dividend exceeds 10% on graded rates. No company is allowed to transfer graded rates. No company is allowed to transfer less than this to the reserves before declaring less than this to the reserves before declaring dividend. dividend.

Dividend Theories Dividend Theories There are various theories that try to There are various theories that try to

explain the relationship of a firm's explain the relationship of a firm's dividend policy and common stock dividend policy and common stock value. value.

Dividend Irrelevance Theory Dividend Irrelevance Theory This theory purports that a firm's This theory purports that a firm's

dividend policy has no effect on dividend policy has no effect on either its value or its cost of capital. either its value or its cost of capital. Investors value dividends and capital Investors value dividends and capital gains equally. gains equally.

DIVIDEND IRRELEVANCE THEORYDIVIDEND IRRELEVANCE THEORY

These theories contend that there are These theories contend that there are two components of shareholder’returns.two components of shareholder’returns.

a)a) Dividend Yield (D / PDividend Yield (D / P00))b)b) Capital Yield (PCapital Yield (P11 - P - P00) / P) / P00))► Suppose a firm issues a Rs.10 par value share at a Suppose a firm issues a Rs.10 par value share at a

premium of Rs.90.premium of Rs.90.► In other words, the issue price is Rs.100. If the firm In other words, the issue price is Rs.100. If the firm

declares a dividend of Rs.3 (the dividend yield is 3%) declares a dividend of Rs.3 (the dividend yield is 3%) price at the end of next year price at the end of next year

► is Rs.115, the capital yield is (115 – 100) / 100 = 15 per is Rs.115, the capital yield is (115 – 100) / 100 = 15 per cent. The total cent. The total

► return to the shareholders is 18 per cent.return to the shareholders is 18 per cent.

These theories, which argue that These theories, which argue that

dividends are not relevant individends are not relevant in determining the value of the firm, are:determining the value of the firm, are:i.i. Residual TheoryResidual Theoryii.ii. Modigliani and Miller (M&M) ModelModigliani and Miller (M&M) Modeliii.iii. Dividend Clientele EffectDividend Clientele Effectiv.iv. Rational Expectations ModelRational Expectations Model

MM's dividend-irrelevance theory assumes MM's dividend-irrelevance theory assumes

that investors can affect their return on a that investors can affect their return on a stock regardless of the stock's dividend. As stock regardless of the stock's dividend. As such, the dividend is irrelevant to an such, the dividend is irrelevant to an investor, meaning investors care little investor, meaning investors care little about a company's dividend policy when about a company's dividend policy when making their purchasing decision since they making their purchasing decision since they can simulate their own dividend policy. can simulate their own dividend policy. According to the model, it is only the firms’ According to the model, it is only the firms’

investment policy that will have an impact on investment policy that will have an impact on the share value of the firm and hence should be the share value of the firm and hence should be given more importance.given more importance.

Dividend Relevance Theory Dividend Relevance Theory

► The dividend is a relevant variable in determining the The dividend is a relevant variable in determining the value of the firm, it implies that there exists an optimal value of the firm, it implies that there exists an optimal dividend policy, which the managers should seek to dividend policy, which the managers should seek to determine, that maximises the value of the firm. determine, that maximises the value of the firm.

► There are three models, which have been developed There are three models, which have been developed under this approach. These are:under this approach. These are:

i)i) Traditional ModelTraditional Modelii)ii) Walter’s ModelWalter’s Modeliii)iii) Gordon’s Dividend Capitalisation ModelGordon’s Dividend Capitalisation Modeliv)iv) Bird-in-hand TheoryBird-in-hand Theoryv)v) Dividend Signalling TheoryDividend Signalling Theoryvi)vi) Agency Cost TheoryAgency Cost Theory

WALTER’S MODELWALTER’S MODEL

Walter Walter put forth the following model for valuation of put forth the following model for valuation of sharesshares

PP00 = = D + (E – D) rlkD + (E – D) rlk kk PP00 = market price per share = market price per share D = Dividend per shareD = Dividend per share E = Earnings per shareE = Earnings per share E – D = Retained earnings per shareE – D = Retained earnings per share r = Firm’s average rate of return r = Firm’s average rate of return k = firm’s cost o capitalk = firm’s cost o capital

From the model it is clear that the market price per share is the sumFrom the model it is clear that the market price per share is the sum of two consumptions:of two consumptions:i.i. The first component Dlk is the present value of an infinite stream of cash flows in The first component Dlk is the present value of an infinite stream of cash flows in

the form of dividends.the form of dividends.ii.ii. The second component The second component (E – D)rlk(E – D)rlk is the present value of an infinite stream of is the present value of an infinite stream of

returns kreturns k► retained earnings.retained earnings.

GORDON’S DIVIDEND CAPITALISATION GORDON’S DIVIDEND CAPITALISATION MODELMODEL

Assumptions : Firm is all-equity, RE are used to finance projects, r Assumptions : Firm is all-equity, RE are used to finance projects, r and k are constant, there are no taxes, b once decided is constant. and k are constant, there are no taxes, b once decided is constant.

Gordon put forward the following valuation model:Gordon put forward the following valuation model:

PP00 = E = E11 + (1 – b) + (1 – b) k - br k - br where, where, PP00 = Price per share at the end of the year 0 = Price per share at the end of the year 0 EE11 = Earnings per share at the end of year 1 = Earnings per share at the end of year 1 (1 – b) = Fraction of earnings the firm distributes by way of (1 – b) = Fraction of earnings the firm distributes by way of

earningsearnings b = Fraction of earnings the firms ploughs backb = Fraction of earnings the firms ploughs back k = Rate of return required by the shareholdersk = Rate of return required by the shareholders r = Rate of return earned on investments made by the firmr = Rate of return earned on investments made by the firm br = Growth rate of earnings and dividendsbr = Growth rate of earnings and dividends

Optimal Dividend Policy Optimal Dividend Policy Proponents believe that there is a Proponents believe that there is a

dividend policy that strikes a balance dividend policy that strikes a balance between current dividends and between current dividends and future growth that maximizes the future growth that maximizes the firm's stock price. firm's stock price.

PRACTICAL CONSIDERATIONS IN THE PRACTICAL CONSIDERATIONS IN THE FORMULATION OF DIVIDEND POLICYFORMULATION OF DIVIDEND POLICY

Profitability and LiquidityProfitability and Liquidity

Legal ConstraintsLegal Constraints

Contractual ConstraintsContractual Constraints

Growth ProspectsGrowth Prospects

Owner ConsiderationsOwner Considerations

Market ConsiderationsMarket Considerations

Industry PracticeIndustry Practice

Shareholders ExpectationsShareholders Expectations

Lots of research and economic logic Lots of research and economic logic

suggests that dividend policy is suggests that dividend policy is irrelevant (in theory). irrelevant (in theory).