Module -2 Dividend Policy 9 hours

Dividend policy – Theories of dividend policy: relevance and irrelevance dividend decision.
Walter’s & Gordon’s model, Modigliani & Miller approach. Dividend policies – stable
dividend, stable pay out and growth. Bonus shares and stock split corporate dividend
behaviour. (Theory and Problems).

INTRODUCTION

The financial manager must take careful decisions on how the profit should be distributed
among shareholders. It is very important and crucial part of the business concern, because
shareholder’s wealth. Like financing decision and investment decision, dividend decision is
also a major part of the financial manager. When the business concerns decide dividend policy,
they have to consider certain factors such as retained earnings and the nature of shareholder of
the business concern.

Meaning of Dividend

Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders.

According to the Institute of Chartered Accountant of India, dividend is defined as “a

distribution to shareholders out of profits or reserves available for this purpose”

TYPES OF DIVIDEND/FORM OF DIVIDEND

Dividend may be distributed among the shareholders in the form of cash or stock. Hence,

Dividends are classified into:

A. Cash dividend

B. Stock dividend

C. Bond dividend

D. Property dividend
Cash Dividend

If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is
paid periodically out the business concerns EAIT (Earnings after interest and tax). Cash
dividends are common and popular types followed by majority of the business concerns.

Stock Dividend

Stock dividend is paid in the form of the company stock due to raising of more finance.
Under this type, cash is retained by the business concern. Stock dividend may be bonus issue.
This issue is given only to the existing shareholders of the business concern.

Bond Dividend

Bond dividend is also known as script dividend. If the company does not have sufficient
funds to pay cash dividend, the company promises to pay the shareholder at a future specific
date with the help of issue of bond or notes.

Property Dividend

Property dividends are paid in the form of some assets other than cash. It will distribute under
the exceptional circumstance. This type of dividend is not published in India.

Interim and final dividend

A company pays an interim dividend before its profits are declared during its Annual General
Meeting (AGM). Companies distribute interim dividends from their retained earnings. A
company's retained earnings are the amount of profit left after paying direct and indirect costs
and taxes. The final dividend, on the other hand, is paid after the company has declared its
financial results. The company’s board of directors declare the interim dividend and final
dividend. Companies can pay an interim dividend for part of a financial year (one-two
quarters). However, the final dividend is always annual. A company has the right to cancel the
interim dividend once announced, but it cannot cancel the final dividend.

BENEFITS OF A DIVIDEND POLICY

A dividend policy will attract investors who are looking for a regular income apart from
capital appreciation through stocks. Investors consider companies that offer dividends as
cash-rich and stable in terms of business. Shareholders feel confident about the company’s
financials on receiving periodic dividend pay-outs. The dividend policy equally benefits the
company and the shareholders in the following ways:

For companies:

• Shareholders exhibit more trust in the company that pays periodic dividends over a
non-dividend paying company.
• Regular dividend payments attract investors who want to invest in robust businesses
and earn a steady income through dividends.

For shareholders:

• The dividend policy clearly and transparently states the terms of dividend distribution
between the shareholders and the company.
• Shareholders of a dividend stock can earn dual income.

Factors Affecting Dividend Policy

1. Stability of Earnings:

Stability of earnings is one of the important factors influencing the dividend policy. If earnings
are relatively stable, a firm is in a better position to predict what its future earnings will be and
such companies are more likely to pay out a higher percentage of its earnings in dividends than
a concern which has fluctuating earnings.

Generally, the concerns which deal in necessities suffer less from fluctuating incomes than
those concern which deal with fancy or luxurious goods.

2. Financing Policy of the Company:

Dividend policy may be affected and influenced by financing policy of the company. If the
company decides to meet its expenses from its earnings, then it will have to pay less dividend
to shareholders. On the other hand, if the company feels, that outside borrowing is cheaper than
internal financing, then it may decide to pay higher rate of dividend to its shareholder. Thus,
the internal financing policy of the company influences the dividend policy of the business
firm.

3. Liquidity of Funds:
The liquidity of funds is an important consideration in dividend decisions. According to
Guthmann and Dougall, although it is customary to speak of paying dividends ‘out of profits’,
a cash dividend only be paid from money in the bank. The presence of profit is an accounting
phenomenon and a common legal requirement, with the -cash and working capital position is
also necessary in order to judge the ability of the corporation to pay a cash dividend.

Payment of dividend means, a cash outflow, and hence, the greater the cash position and
liquidity of the firm is determined by the firm’s investment and financing decisions. While the
investment decisions determine the rate of asset expansion and the firm’s needs for funds, the
financing decisions determine the manner of financing.

4. Dividend, Policy of Competitive Concerns:

Another factor which influences, is the dividend policy of other competitive concerns in the
market. If the other competing concerns, are paying higher rate of dividend than this concern,
the shareholders may prefer to invest their money in those concerns rather than in this concern.
Hence, every company will have to decide its dividend policy, by keeping in view the dividend
policy of other competitive concerns in the market.

5. Past Dividend Rates:

If the firm is already existing, the dividend rate may be decided on the basis of dividends
declared in the previous years. It is better for the concern to maintain stability in the rate of
dividend and hence, generally the directors will have to keep in mind the rate of dividend
declared in the past.

6. Debt Obligations:

A firm which has incurred heavy indebtedness, is not in a position to pay higher dividends to
shareholders. Earning retention is very important for such concerns which are following a
programme of substantial debt reduction. On the other hand, if the company has no debt
obligations, it can afford to pay higher rate of dividend.

7. Ability to Borrow:

Every company requires finance both for expansion programmes as well as for meeting
unanticipated expenses. Hence, the companies have to borrow from the market, well
established and large firms have better access to the capital market than new and small, firms
and hence, they can pay higher rate of dividend. The new companies generally find it difficult
to borrow from the market and hence they cannot afford to pay higher rate of dividend.

8. Growth Needs of the Company:

Another factor which influences the rate of dividend is the growth needs of the company. In
case the company has already expanded considerably, it does not require funds for further
expansions. On the other hand, if the company has expansion programmes, it would need more
money for growth and development. Thus when money for expansion is not, needed, then it is
easy for the company to declare higher rate of dividend.

9. Profit Rate:

Another important consideration for deciding the dividend is the profit rate of the firm. The
internal profitability rate of the firm provides a basis for comparing the productivity of retained
earnings to the alternative return which could be earned elsewhere. Thus, alternative
investment opportunities also play an important role in dividend decisions.

10. Legal Requirements:

While declaring dividend, the board of directors will have to consider the legal restriction. The
Indian Companies Act, 1956, prescribes certain guidelines in respect of declaration and
payment of dividends and they are to be strictly observed by the company for declaring
dividends.

11. Policy of Control:

Policy of control is another important factor which influences dividend policy. If the company
feels that no new shareholders should be added, then it will have to pay less dividends.
Generally, it is felt, that new shareholders, can dilute the existing control of the management
over the concern. Hence, if maintenance of existing control is an important consideration, the
rate of dividend may be lower so that the company can meet its financial requirements from its
retained earnings without issuing additional shares to the public

12. Corporate Taxation Policy:

Corporate taxes affect the rate of dividends of the concern. High rates of taxation reduce the
residual profits available for distribution to shareholders. Hence, the rate of dividend is
affected. Further, in some circumstances, government puts dividend tax on distribution of
dividends beyond a certain limit. This may also affect rate of dividend of the concern.
13. Tax Position of Shareholders:

The tax position of shareholders is another influencing factor on dividend decisions. In a

company if a large number of shareholders have already high income from other sources and
are bracketed in high income structure, they will not be interested in high dividends because
the large part of the dividend income will go away by way of income tax. Hence, they prefer
capital gains to cash gains, i.e., dividend capital gains here we mean capital benefit derived by
the capitalisation of the reserves or issue of bonus shares.

Instead of receiving the dividend in the form of cash (whatever may be the per cent), the
shareholders would like to get shares and increase their holding in the form of shares. This has
certain benefits to shareholders. They get money by selling these extra shares received in
proportion to their original shareholding.

This will be a capital gain for them. Of course, they have to pay tax on capital gains. But the
capital gains tax will be less compared to the income-tax that they should have paid when cash
dividend was declared and added to the personal income of the shareholders.

14. Effect of Trade Cycle:

Trade cycle also influences the dividend policy of the concern. For example, during the period
of inflation, funds generated from depreciation may not be adequate to replace the assets.
Consequently, there is a need for retained earnings in order to preserve the earning power of
the firm.

15. Attitude of the Interested Group:

A concern may have certain group of interested and powerful shareholders. These people have
certain attitude towards payment of dividend and have a definite say in policy formulation
regarding dividend payments. If they are not interested in higher rate of dividend, shareholders
are not likely to get that. On the other hand, if they are interested in higher rate of dividend,
they will manage to make company declare higher rate of dividend even in the face of many
odds.
TYPES OF DIVIDEND POLICY

The dividend policy used by a company can affect the value of the enterprise. The policy
chosen must align with the company’s goals and maximize its value for its shareholders. While
the shareholders are the owners of the company, it is the board of directors who make the call
on whether profits will be distributed or retained.

The directors need to take a lot of factors into consideration when making this decision, such
as the growth prospects of the company and future projects. There are various dividend policies
a company can follow such as:

Stable Dividend Policy

A stable dividend policy involves fixing a certain amount of dividend that the shareholders
periodically receive. Even if the company incurs a loss, the amount of dividend does not
change.

Regular Dividend Policy

In a regular dividend policy, the company fixes a certain percentage of dividend from the
company’s profits. When the profits are high, the dividend payment will automatically be high.
While the profits are low, the dividend payment will remain low. Experts usually considers this
to be the most appropriate policy for paying dividends and creating goodwill.

Irregular Dividend Policy

In an irregular dividend policy, the dividend payment solely depends on the company’s
decision. If the company decides to pay a dividend to the shareholders, then the shareholders
get the dividend. The decision solely depends on the company’s priorities. If the company has
a new project to fund, then it may decide to retain the profits within the company instead of
distributing it.

No Dividend Policy

In no dividend policy, the company always retains the profits and doesn’t distribute them to its
shareholders. Usually, growth-oriented companies follow the no dividend policy. The strategy
might suit companies who aim for growth. However, it may discourage investors who are
looking for sustainable income in the long term.
THEORIES OF DIVIDEND POLICY

Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long-term growth. Hence, dividend
decision plays very important part in the financial management. Dividend decision consists of
two important concepts which are based on the relationship between dividend decision and
value of the firm.

Irrelevance of Dividend

According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the
share price of the company. There is no relation between the dividend rate and value of the
firm. Dividend decision is irrelevant of the value of the firm. Modigliani and Miller contributed
a major approach to prove the irrelevance dividend concept.

Modigliani and Miller’s Approach

According to MM, under a perfect market condition, the dividend policy of the company is
irrelevant and it does not affect the value of the firm. “Under conditions of perfect 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
the market price of shares”.

Assumptions

MM approach is based on the following important assumptions:

 1. Perfect capital market.

2. Investors are rational.

3. There are no tax.

4. The firm has fixed investment policy.

5. No risk or uncertainty

Relevance of Dividend

According to this concept, dividend policy is considered to affect the value of the firm.
Dividend relevance implies that shareholders prefer current dividend and there is no direct
relationship between dividend policy and value of the firm. Relevance of dividend concept is
supported by two eminent persons like Walter and Gordon.

Walter’s Model

Prof. James E. Walter argues that the dividend policy almost always affects the value of the
firm.

Walter model is based in the relationship between the following important factors:

• Rate of return I

• Cost of capital (k)

According to the Walter’s model, if r > k, the firm is able to earn more than what then
shareholders could by reinvesting, if the earnings are paid to them. The implication of r > k is
that the shareholders can earn a higher return by investing elsewhere. If the firm has r = k, it
is a matter of indifferent whether earnings are retained or distributed.

Assumptions

Walters model is based on the following important assumptions:

1. The firm uses only internal finance.

2. The firm does not use debt or equity finance.

3. The firm has constant return and cost of capital.

4. The firm has 100 recent pay out.

 5. The firm has constant EPS and dividend.

6. The firm has a very long life

Criticism of Walter’s Model

The following are some of the important criticisms against Walter model:

• Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
• There is no possibility of constant return. Return may increase or decrease, depending
upon the business situation. Hence, it is applicable.
• According to Walter model, it is based on constant cost of capital. But it is not
applicable in the real life of the business.

Gordon’s Model

Myron Gorden suggests one of the popular models which assume that dividend policy of a
firm affects its value, and it is based on the following important assumptions:

1. The firm is an all-equity firm.

2. The firm has no external finance.
3. Cost of capital and return are constant.
4. The firm has perpetual life.
5. There are no taxes.
6. Constant relation ratio (g=br).
7. Cost of capital is greater than growth rate (Ke>br)

Criticism of Gordon’s Model

Gordon’s model consists of the following important criticisms:

Gordon model assumes that there is no debt and equity finance used by the firm. It is not
applicable to present day business. Ke and r cannot be constant in the real practice.

According to Gordon’s model, there are no tax paid by the firm. It is not practically
applicable.