Dividend Policy

Meaning and Types

 Once a company makes a profit, they must decide on what to do
with those profits.
 They could continue to retain the profits within the company, or
 they could pay out the profits to the owners of the firm in the form of
dividends.
 Once the company decides on whether to pay dividends, they may
establish a somewhat permanent dividend policy, which may in turn
impact on investors and perceptions of the company in the financial
markets.
 What they decide depends on the situation of the company now and
in the future.
 It also depends on the preferences of investors and potential
investors.
 These policies shape the attitude of the investors and the
financial market in general towards the concerned company.
 Types of Dividend Policy
 (1) Policy of No Immediate Dividend:
 Generally, management follows a policy of paying no
immediate dividend in the beginning of its life, as it
requires funds for growth and expansion.
 In case, when the outside funds are costlier or when the
access to capital market is difficult for the company and
shareholders are ready to wait for dividend for
sometime, this policy is justified, provided the company
is growing fast and it requires a good deal of amount for
expansion.
 But such a policy is not justified for a long time, as the
shareholders are deprived of the dividend.
 (2)Regular or Stable Dividend
Policy:
 When a company pays dividend regularly at a fixed rate,
and maintains it for a considerably long time even
though the profits may fluctuate, it is said to follow
regular or stable dividend policy
 . Thus stable dividend policy means a policy of paying a
minimum amount of dividend every year regularly.
 It raises the prestige of the company in the eyes of the
investors.
 Not only that the dividend must be regularly paid but the
dividend must be stable .
 It may be fixed amount per share or a fixed percentage
of net profits or it may be total fixed amount of dividend
on all the shares etc.
 (3) Regular Dividend plus Extra
Dividend Policy.
 A firm paying regular dividends would continue with its
pay out ratio.
 But when the earnings exceed the normal level, the
directors would pay extra dividend in addition to the
regular dividend.
 But it would be named 'Extra dividend', as it should not
give an impression that the company has enhanced rate
of regular dividend.
 This would give an impression to shareholders that the
company has given extra dividend because it has earned
extra profits and would not be repeated when the
business earnings become normal.
 This system is not found in India.
(4) Irregular Dividend Policy:
 When the firm does not pay out fixed dividend
regularly, it is irregular dividend policy.
 It changes from year to year according to
changes in earnings level.
 This policy is based on the management belief
that dividend should be paid only when the
earnings and liquid position of the firm warrant it.
 This policy is followed by firms having unstable
earnings
 (5) Regular Stock Dividend
Policy:
 When a firm pays dividend in the form of
shares instead of cash regularly for some
years continuously, it is said to follow this
policy.
 We know stock dividend as bonus shares.
 (6) Regular Dividend plus Stock
Dividend Policy:
 A firm may pay certain amount of dividend
in cash and some dividend is paid in the
form of shares (stock).
 (7) Liberal Dividend Policy:
 It is a policy of distributing a major part of
its earnings to its shareholders as dividend
and retains a minimum amount as
retained earnings.
 Factors Affecting Dividend Policy
 A number of considerations affect the dividend policy of
company. The major factors are

 1. Stability of Earnings. The nature of business has

an important bearing on the dividend policy. Industrial
units having stability of earnings may formulate a more
consistent dividend policy than those having an uneven
flow of incomes because they can predict easily their
savings and earnings.
 Usually, enterprises dealing in necessities suffer less
from oscillating earnings than those dealing in luxuries
or fancy goods.
 2. Age of corporation.
 Age of the corporation counts much in
deciding the dividend policy.
 A newly established company may require
much of its earnings for expansion and
plant improvement and may adopt a rigid
dividend policy
 while, on the other hand, an older
company can formulate a clear cut and
more consistent policy regarding dividend.
 3. Liquidity of Funds.
 Availability of cash and sound financial position
is also an important factor in dividend decisions.
 A dividend represents a cash outflow, the
greater the funds and the liquidity of the firm
the better the ability to pay dividend.
 The liquidity of a firm depends very much on the
investment and financial decisions of the firm
which in turn determines the rate of expansion
and the manner of financing.
 If cash position is weak, stock dividend will be
distributed and if cash position is good, company
can distribute the cash dividend
 4. Extent of share Distribution.
 Nature of ownership also affects the dividend
decisions.
 A closely held company is likely to get the assent
of the shareholders for the suspension of
dividend or for following a conservative dividend
policy.
 On the other hand, a company having a good
number of shareholders widely distributed and
forming low or medium income group, would
face a great difficulty in securing such assent
because they will emphasise to distribute higher
dividend.
 5. Needs for Additional Capital.
 . Companies retain a part of their profits for
strengthening their financial position.
 The income may be conserved for meeting the
increased requirements of working capital or of
future expansion.
 Small companies usually find difficulties in
raising finance for their needs of increased
working capital for expansion programmes.
 They having no other alternative, use their
ploughed back profits. Thus, such Companies
distribute dividend at low rates and retain a big
part of profits.
 6. Trade Cycles
 Business cycles also exercise influence upon dividend
Policy.
 Dividend policy is adjusted according to the business
oscillations.
 During the boom, prudent management creates food
reserves for contingencies which follow the inflationary
period.
 Higher rates of dividend can be used as a tool for
marketing the securities in an otherwise depressed
market.
 The financial solvency can be proved and maintained by
the companies in dull years if the adequate reserves
have been built up.
 7. Government Policies.
 The earnings capacity of the enterprise is widely
affected by the change in fiscal, industrial,
labour, control and other government policies.
 Sometimes government restricts the distribution
of dividend beyond a certain percentage in a
particular industry or in all spheres of business
activity as was done in emergency.
 The dividend policy has to be modified or
formulated accordingly in those enterprises.
 8. Taxation Policy.
 High taxation reduces the earnings of he
companies and consequently the rate of
dividend is lowered down.
 9. Legal Requirements.
 In deciding on the dividend, the directors take
the legal requirements too into consideration.
 In order to protect the interests of creditors and
outsiders, the companies Act 1956 prescribes
certain guidelines in respect of the distribution
and payment of dividend
 It proposes that Dividend should not be
distributed out of capita, in any case.
 Likewise, contractual obligation should also be
fulfilled, for example, payment of dividend on
preference shares in priority over ordinary
dividend.
 10. Past dividend Rates.
 While formulating the Dividend Policy, the
directors must keep in mind the dividend paid in
past years.
 The current rate should be around the average
past rat. If it has been abnormally increased the
shares will be subjected to speculation.
 In a new concern, the company should consider
the dividend policy of the rival organisation.
 11. Ability to Borrow.
 Well established and large firms have better
access to the capital market than the new
Companies and may borrow funds from the
external sources if there arises any need.
 Such Companies may have a better dividend
pay-out ratio.
 Whereas smaller firms have to depend on their
internal sources and therefore they will have to
built up good reserves by reducing the dividend
pay out ratio for meeting any obligation
requiring heavy funds.
 12. Policy of Control.
 Policy of control is another determining factor is so far
as dividends are concerned.
 If the directors want to have control on company, they
would not like to add new shareholders and therefore,
declare a dividend at low rate.
 Because by adding new shareholders they fear dilution
of control and diversion of policies and programmes of
the existing management.
 So they prefer to meet the needs through retained
earing. If the directors do not bother about the control
of affairs they will follow a liberal dividend policy.
 Thus control is an influencing factor in framing the
dividend policy.
 13. Repayments of Loan.
 A company having loan indebtedness are vowed to a
high rate of retention earnings, unless one other
arrangements are made for the redemption of debt on
maturity.
 It will naturally lower down the rate of dividend.
Sometimes, the lenders (mostly institutional lenders) put
restrictions on the dividend distribution still such time
their loan is outstanding.
 Formal loan contracts generally provide a certain
standard of liquidity and solvency to be maintained.
Management is bound to hour such restrictions and to
limit the rate of dividend payout.
 14. Time for Payment of
Dividend.
 When should the dividend be paid is another
consideration. Payment of dividend means
outflow of cash.
 It is, therefore, desirable to distribute dividend
at a time when is least needed by the company
because there are peak times as well as lean
periods of expenditure.
 Wise management should plan the payment of
dividend in such a manner that there is no cash
outflow at a time when the undertaking is
already in need of urgent finances.
 15 Attitude of Management
 The attitude of management has considerable
impact on dividend policy.
 The management with foresight and
conservative attitude would declare lower
dividend and major part of the profit would be
kept in business to strengthen its financial
position.
 The management with liberal attitude would be
liberal in dividend policy. Prudent management
would always adopt a bit conservative dividend
policy.
16 Present Amount of Reserves
 A company having sufficient amount of reserves would
be able to face the times of low demand with
confidence, the prudent management would therefore,
try to build up, sufficient reserves during boom period by
restricting the rate of dividend and thus try to
strengthen its financial position.
 Of course, in India it has been made compulsory by
Companies Act that companies are required to transfer
not more than 10% of their net profits to Reserve if the
rate of dividend exceeds 10% on graded rates. No
company is allowed to transfer less than this to the
reserves before declaring dividend.
 Dividend Theories
 There are various theories that try to
explain the relationship of a firm's
dividend policy and common stock value.
 Dividend Irrelevance Theory
 This theory purports that a firm's dividend
policy has no effect on either its value or
its cost of capital. Investors value
dividends and capital gains equally.
 DIVIDEND IRRELEVANCE THEORY
 These theories contend that there are two
components of shareholder’returns.
a) Dividend Yield (D / P0)
b) Capital Yield (P1 - P0) / P0)

► Suppose a firm issues a Rs.10 par value share at a premium of

Rs.90.
► In other words, the issue price is Rs.100. If the firm declares a
dividend of Rs.3 (the dividend yield is 3%) price at the end of
next year
► is Rs.115, the capital yield is (115 – 100) / 100 = 15 per cent.
The total
► return to the shareholders is 18 per cent.
 These theories, which argue that
dividends are not relevant in
determining the value of the firm, are:
i. Residual Theory
ii. Modigliani and Miller (M&M) Model

iii. Dividend Clientele Effect

iv. Rational Expectations Model

 MM's dividend-irrelevance theory assumes that
investors can affect their return on a stock
regardless of the stock's dividend. As such, the
dividend is irrelevant to an investor, meaning
investors care little about a company's dividend
policy when making their purchasing decision
since they can simulate their own dividend
policy.
 According to the model, it is only the firms’ investment
policy that will have an impact on the share value of
the firm and hence should be given more importance.
 Dividend Relevance Theory
► The dividend is a relevant variable in determining the value of
the firm, it implies that there exists an optimal dividend policy,
which the managers should seek to determine, that maximises
the value of the firm.
► There are three models, which have been developed under this
approach. These are:

i) Traditional Model
ii) Walter’s Model
iii) Gordon’s Dividend Capitalisation Model
iv) Bird-in-hand Theory
v) Dividend Signalling Theory
vi) Agency Cost Theory
 WALTER’S MODEL
Walter put forth the following model for valuation of shares
 P0 = D + (E – D) rlk
 k
 P0 = market price per share
 D = Dividend per share
 E = Earnings per share
 E – D = Retained earnings per share
 r = Firm’s average rate of return
 k = firm’s cost o capital

 From the model it is clear that the market price per share is the sum
 of two consumptions:
i. The first component Dlk is the present value of an infinite stream of cash flows in the form of
dividends.
ii. The second component (E – D)rlk is the present value of an infinite stream of returns k
► retained earnings.
 GORDON’S DIVIDEND CAPITALISATION
MODEL
 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.
 Gordon put forward the following valuation model:

 P0 = E1 + (1 – b)
 k - br
 where,
 P0 = Price per share at the end of the year 0
 E1 = Earnings per share at the end of year 1
 (1 – b) = Fraction of earnings the firm distributes by way of earnings
 b = Fraction of earnings the firms ploughs back
 k = Rate of return required by the shareholders
 r = Rate of return earned on investments made by the firm
 br = Growth rate of earnings and dividends
 Optimal Dividend Policy
 Proponents believe that there is a dividend
policy that strikes a balance between
current dividends and future growth that
maximizes the firm's stock price.
 PRACTICAL CONSIDERATIONS IN THE
FORMULATION OF DIVIDEND POLICY
 Profitability and Liquidity

 Legal Constraints

 Contractual Constraints

 Growth Prospects

 Owner Considerations

 Market Considerations

 Industry Practice

 Shareholders Expectations
 Lots of research and economic logic
suggests that dividend policy is irrelevant
(in theory).