Module V: Dividend Decisions

Dividend Decisions-Dividend Policy-Conservative Vs Liberal policy-Pay-out ratio, Retention

ratio-Dividend theories-Irrelevance theory-Modigliani-Miller Hypothesis; Relevance
theoriesWalter’s Model, Gordon’s Model-Determinants of dividend policy-Bonus shares, Stock
split.

Dividend Decisions

Once a company makes a profit, it 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.
DEFINITION: DIVIDEND
According to the Institute of Chartered Accountants of India, dividend is "a distribution to
shareholders out of profits or reserves available for this purpose."
"The term dividend refers to that portion of profit (after tax) which is distributed among the
owners / shareholders of the firm”.
In other words, dividend is that part of the net earnings of a corporation that is distributed to its
stockholders. It is a payment made to the equity shareholders for their investment in the
company.
Dividend is a reward to equity shareholders for their investment in the company. It is a basic
right of equity shareholders to get dividend from the earnings of a company.

DEFINITION: DIVIDEND POLICY

"Dividend policy determines the ultimate distribution of the firm's earnings between retention
(that is reinvestment) and cash dividend payments of shareholders."
"Dividend policy means the practice that management follows in making dividend payout
decisions, or in other words, the size and pattern of cash distributions over the time to
shareholders."
In other words, dividend policy is the firm's plan of action to be followed when dividend
decisions are made. It is the decision about how much of earnings to pay out as dividends versus
retaining and reinvesting earnings in the firm.
Dividend policy must be evaluated in light of the objective of the firm namely, to choose a policy
that will maximize the value of the firm to its shareholders. The dividend policy of a company
reflects how prudent its financial management is. The future prospects, expansion, diversification
mergers are effected by dividing policies and for a healthy and buoyant capital market, both
dividends and retained earnings are important factors.
As we know in corporation, owners are shareholders but management is done through Board of
directors. It is the Board of Directors to decide whether to pay dividend or retain earnings for
future projects. It is a matter of conflict between shareholders and directors. Shareholders expect
a quick return on their capital. On the other hand, directors have to consider a number of factors
in determining divided policy.
Most of the company follows some kind of dividend policy. The usual policy of a company is to
retain a position of net earnings and distribute the remaining amount to the shareholders. Many
factors have to be evaluated before forming a long term dividend policy.

TYPES OF DIVIDENDS:
Classifications of dividends are based on the form in which they are paid. Following given below
are the different types of dividends:
i. Cash dividend
ii. Bonus Shares referred to as stock dividend
iii. Property dividend interim dividend, annual dividend.
iv. Special- dividend, extra dividend etc.
v. Regular Cash dividend
vi. Scrip dividend
vii. Liquidating dividend
viii. Property dividend
THE DIVIDEND DECISION
The company's Board of Directors makes dividend decisions. They are faced with the decision to
pay out dividends or to reinvest the cash into new projects.

Dividend policies must always consider two basic objectives:

1. Maximizing owners' wealth
2. Providing sufficient financing

Type of Dividend Policy

1. Generous or liberal dividend policy: Firms that follow this policy reward shareholders
generously by stepping up dividend over the time.
2. Stable dividend policy: Firms may follow the policy of: Stable dividend payout ratio:
According to this policy, the percentage of earnings paid out of dividends remains constant. The
dividends will fluctuate with the earnings of the company. Stable rupee (inflation adjusted)
dividend policy: As per this policy the rupee level of dividends
remains stable.
3. Low regular dividend plus extra dividend policy: As per this policy, a low, regular dividend
is maintained and when times are good an extra dividend is paid. Extra dividend is the additional
dividend optionally paid by the firm if earnings are higher than normal in a given period.
Although the regular portion will be predictable, the total dividend will be unpredictable.
4. Residual dividend policy: Under this policy, dividends are paid out of earnings not needed to
finance new acceptable capital projects. The dividends will fluctuate depending on investment
opportunities available to the company.
5. Multiple dividend increase policy: Some firms follow the policy of very frequent and small
dividend increases. The objective is to give shareholders an illusion of movement and growth.
6. Uniform cash dividend plus bonus policy: Under this policy, the minimum rate of dividend
per share is paid in cash plus bonus shares are issued out of accumulated reserves. However,
bonus shares are not given compulsorily on an annual basis. They may be given over a period of
a certain number of years, for example 3-5 years depending on the accumulated reserves of the
company that can be utilized for the purpose of issuing bonus.
Conservatives vs. Liberals

Sources of Economic Instability. Conservatives generally favor free markets and consider
government interventions in these markets as the major source of all economic instability.
Specifically, governments are accused of creating uncertainties by their constant changes in
economic policies and regulations, thus making it harder for private businesses to effectively
plan their future activities. In addition, benevolent but misguided government policies, such as
attempts at wider home ownership, imposition of minimum wages, and excessively easy
monetary policy, create conditions that may have temporary benefits, but will result in
unintended and harmful long term consequences.
For liberals, on the other hand, it is the combination of unbridled free markets and their private
sector participants which causes all our economic problems. It is the private sector which creates
all recurring booms and busts in the economy through excessive leverage and speculation, thus
necessitating frequent government bailouts and stabilization policies. This is why many liberals
currently point to private speculators and their greedy financiers as the main culprits behind the
latest housing crash and its recessionary consequences.
Rules versus Discretion in Economic Policy. Conservatives, skeptical about governmental
ability to gather relevant and timely economic data and their use in implementing appropriate
discretionary policies, prefer automatic policy rules, such as balanced budgets, fixed money
supply growth rates, flexible exchange rates, and market-determined incomes. Such rules are
expected to provide a more predictable environment, compared to erratic discretionary actions
that may only serve to confuse businesses and, thus, to further destabilize the economy. In
addition, conservatives particularly dislike all types of income and wealth redistribution policies,
misguided and counterproductive attempts to reward the unproductive “takers” and to punish the
productive “makers.”
In contrast, liberals reject all automatic policy rules, as they consider modern economies
vulnerable to a host of random shocks, such as wars, commodity price movements, and
disruptive technological advances. Under these conditions, which could adversely affect
production and employment levels, liberals favor a more hands-on policy approach, not unlike
the situation of driving along a winding road with both hands on the wheel, as using the cruise
control can prove hazardous. Hence, the argument by liberals that if the Fed had heeded the
conservative call for a fixed money growth rule during the crisis of 2008, the rush to liquidity by
panicked investors would have severely lowered asset prices and, therefore, irretrievably
damaged the financial system.
Fiscal versus Monetary policy in Economic Stabilization. Conservatives generally favor
monetary policy as a stabilization tool, as they consider fiscal actions as synonymous with
spending on wasteful social programs, budget deficits, government borrowings, higher interest
rates, and the crowding out of useful private investment. Liberals, in contrast, consider monetary
policy too slow and weak to address sudden and drastic declines in aggregate demand in the
economy.
Specifically, liberals point out that lower interest rates generated by easy monetary policy will
fail to stimulate the economy, as many borrowers will be reluctant to add to their debt loads
during hard economic times. Instead, liberals tend to favor more public spending on
infrastructure, education, unemployment benefits, and similar demand-boosting projects. The
relative impotency of monetary policy during the recent crisis to create a meaningful economic
recovery is often cited by liberals as a case supporting their position.
Causes of Inflation. To conservatives, inflation is always and everywhere caused by excessive
monetary expansion, that is, by too much money chasing too few goods. Liberals largely reject
this inflation model as being applicable only to the third world countries. In these countries,
printing of money is often used by governments as a substitute for tax revenues, thus generating
too much demand for goods and services, which in the face of supply limitations, can create
inflationary pressures. In modern industrial countries, however, where there is a general tendency
for over-production, inflation is mainly caused by increases in production costs, such as wages
and commodity prices. In addition, during deep recessionary periods, such as we are
experiencing right now, production costs rarely increase, thus keeping inflation at bay.
As evidence, liberals point to the experience of the Great Recession, during which many central
banks massively increased their money supplies and thus, to believe conservatives, subjected
their economies to the immanent threats of hyperinflation. In reality, of course, as liberals keep
asserting, the bulk of the newly created monies seems to have been hoarded, with no appreciable
impact on inflation rates. Needless to add, home prices in some US cities, especially those in the
South or on the Coasts, have begun to rise as a result of the energy boom and real estate
speculation. But again, according to liberals, given the backdrop of the generally weak US
economy, this housing boom can only be short-lived.

Payout Ratio
The payout ratio is a financial metric showing the proportion of earnings a company pays its
shareholders in the form of dividends, expressed as a percentage of the company's total earnings.
On some occasions, the payout ratio refers to the dividends paid out as a percentage of a
company's cash flow. The payout ratio is also known as the dividend payout ratio.
A low payout ratio can signal that a company is reinvesting the bulk of its earnings into
expanding operations.
A payout ratio over 100% indicates that the company is paying out more in dividends than its
earning can support, which some view as an unsustainable practice.
The payout ratio is a key financial metric used to determine the sustainability of a company’s
dividend payment program. It is the amount of dividends paid to shareholders relative to the total
net income of a company.

Payout Ratio Formula

DPR= Total dividends / Net income
Where: DPR=Divided payout ratio (or simply payout ratio)

Some companies pay out all their earnings to shareholders, while others dole out just a portion
and funnel the remaining assets back into their businesses. The measure of retained earnings is
known as the retention ratio. The higher the retention ratio is, the lower the payout ratio is. For
example, if a company reports a net income of $100,000 and issues $25,000 in dividends, the
payout ratio would be $25,000 / $100,000 = 25%. This implies that the company boasts a 75%
retention ratio, meaning it records the remaining $75,000 of its income for the period in its
financial statements as retained earnings, which appears in the equity section of the company's
balance sheet the following year.
​
Retention Ratio
The retention ratio is the proportion of earnings kept back in the business as retained earnings.
The retention ratio refers to the percentage of net income that is retained to grow the business,
rather than being paid out as dividends. It is the opposite of the payout ratio, which measures the
percentage of profit paid out to shareholders as dividends. The retention ratio is also called the
plowback ratio.
After dividends have been paid out, the amount of profit left over is known as retained earnings.
The retention ratio helps investors determine how much money a company is keeping to reinvest
in the company's operations.
Growing companies typically have high retention ratios as they are investing earnings back into
the company to grow rapidly.
Companies that make a profit at the end of a fiscal period can use the funds for a number of
purposes. The company's management can pay the profit to shareholders as dividends, they can
retain it to reinvest in the business for growth, or they can do some combination of both. The
portion of the profit that a company chooses to retain or save for later use is called retained
earnings.

How to Calculate the Retention Ratio

The formulas for the retention ratio are

Retention Ratio= Retained Earnings / Net Income

or the alternative formula is:
Retention Ratio= Net Income− Dividends Distributed / Net Income

Determinants of Dividend Policy​

​Some of the most important determinants of dividend policy are: (i) Type of Industry (ii) Age of
Corporation (iii) Extent of share distribution (iv) Need for additional Capital (v) Business Cycles
(vi) Changes in Government Policies (vii) Trends of profits (vii) Trends of profits (viii) Taxation
policy (ix) Future Requirements and (x) Cash Balance.
The declaration of dividends involves some legal as well as financial considerations. From the
point of legal considerations, the basic rule is that dividend can only be paid out profits without
the impairment of capital in any way. But the various financial considerations present a difficult
situation to the management for coming to a decision regarding dividend distribution.

(i) Type of Industry:

Industries that are characterised by stability of earnings may formulate a more consistent policy
as to dividends than those having an uneven flow of income. For example, public utilities
concerns are in a much better position to adopt a relatively fixed dividend rate than the industrial
concerns.

(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant improvement and
expansion, while old companies which have attained a longer earning experience, can formulate
clear cut dividend policies and may even be liberal in the distribution of dividends.

(iii) Extent of share distribution:

A closely held company is likely to get consent of the shareholders for the suspension of
dividends or for following a conservative dividend policy. But a company with a large number of
shareholders widely scattered would face a great difficulty in securing such assent. Reduction in
dividends can be affected but not without the co-operation of shareholders.

(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has got a considerable
influence on the dividend policy. The income may be conserved for meeting the increased
requirements of working capital or future expansion.

(v) Business Cycles:

During the boom, prudent corporate management creates good reserves for facing the crisis
which follows the inflationary period. Higher rates of dividend are used as a tool for marketing
the securities in an otherwise depressed market.
(vi) Changes in Government Policies:
Sometimes government limits the rate of dividend declared by companies in a particular industry
or in all spheres of business activity. The Government put temporary restrictions on payment of
dividends by companies in July 1974 by making amendment in the Indian Companies Act, 1956.
The restrictions were removed in 1975.

(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to find out the average
earning position of the company. The average earnings should be subjected to the trends of
general economic conditions. If depression is approaching, only a conservative dividend policy
can be regarded as prudent.

(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the
residual profits after tax available for shareholders and indirectly, as the distribution of dividends
beyond a certain limit is itself subject to tax. At present, the amount of dividend declared is tax
free in the hands of shareholders.

(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the
business, to finance future- expansion of the business and to modernise or replace equipments of
the enterprise. The conflicting claims of dividends and accumulations should be equitably settled
by the management.

(x) Cash Balance:

If the working capital of the company is small liberal policy of cash dividend cannot be adopted.
Dividend has to take the form of bonus shares issued to the members in lieu of cash payment.
Bonus Share
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 company's
accumulated earnings which are not given out in the form of dividends, but are converted into
free shares.
Companies issue bonus shares to encourage retail participation and increase their equity base.
When price per share of a company is high, it becomes difficult for new investors to buy shares
of that particular company. Increase in the number of shares reduces the price per share. But the
overall capital remains the same even if bonus shares are declared.
Bonus shares are an additional number of shares given by the company to its existing
shareholders as “BONUS” when they are not in the position to pay a dividend to its shareholders
despite earning decent profits for that quarter.
Only a company has the right to issue bonus shares to their shareholders, which has earned
massive profit or large free reserves that cannot be utilized for any particular purpose and can be
distributed as dividends.
However, these bonus shares are given to the shareholders according to their existing stake in the
company.

Advantages of Bonus Shares

From Investor's Point of View

1) Investors do not have to pay any tax while receiving bonus shares from the company.
2) Bonus shares are considered beneficial for long-term shareholders of the company looking to
multiply their investment.
3) Bonus shares are free of cost to shareholders as they are issued by the company, which
increases the outstanding shares of an investor in the company and enhances the liquidity of the
stock.
4) Bonus shares help build the trust of an investor in the company's business and operations
because they have invested in the company and, in turn, gives capital to the investor.
From Company's Point of View
1) The issue of bonus shares enhances the company's value and increases positions and image in
the market, gaining the trust of existing shareholders and attracting several small investors to be
a part of the stock market.
2) The companies have more free-floating shares with the issue of bonus shares in the market.
3) Issue of Bonus shares benefits companies to get themselves out of the situation where they are
not able to or simply not prefer to pay cash dividends to their shareholders.

Disadvantages of Bonus Shares

From Investor’s Point of View
1) There is no much of a disadvantage of owning the bonus shares from an investor’s point of
view. However, they should know about receiving bonus shares because the profit will remain
the same, but the number of shares will be increased as the earning per share will fall.
From Company’s Point of View
1) The company do not receive any cash while issuing bonus shares. As a result, the ability to
raise money by following an offering is minimized.
2) When a company keep on issuing bonus shares instead of paying dividends, the cost of the
bonus issued keeps adding up over the years.

Stock Split
All publicly traded companies have a set number of shares that are outstanding. A stock split is a
decision by a company's board of directors to increase the number of shares outstanding by
issuing more shares to current shareholders.
For example, in a 2-for-1 stock split, a shareholder receives an additional share for each share
held. So, if a company had 10 million shares outstanding before the split, it will have 20 million
shares outstanding after a 2-for-1 split.
A stock's price is also affected by a stock split. After a split, the stock price will be reduced
(because the number of shares outstanding has increased). In the example of a 2-for-1 split, the
share price will be halved. Thus, while a stock split increases the number of outstanding shares
and proportionally lowers the share price, the company's market capitalization remains
unchanged.
Why Do Companies Engage in Stock Splits?
When a company's share price increases to a nominal level that may make some investors
uncomfortable, or is beyond the share prices of similar companies in the same sector, the
company's board may decide on a stock split. A stock split can make the shares seem more
affordable, even though the underlying value of the company has not changed. It can also
increase the stock's liquidity.

What Is a Reverse Stock Split?

Another version of a stock split is called a reverse split. This procedure is typically used by
companies with low share prices that would like to increase their prices. A company may do this
if they are afraid their shares are going to be delisted or as a way of gaining more respectability
in the market. Many stock exchanges will delist stocks if they fall below a certain price per
share.
For example, in a reverse one-for-five split, 10 million outstanding shares at $0.50 cents each
would now become 2 million shares outstanding at $2.50 per share. In both cases, the company
is still worth $5 million.

Theories of Dividend: Walter’s model, Gordon’s model and Modigliani and

Miller’s Hypothesis

1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost always affects the
value of the enterprise. His model shows clearly the importance of the relationship between the
firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that
will maximise the wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is not
issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and
the divided per share (D) may be changed in the model to determine results, but any given values
of E and D are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.

Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under
different assumptions about the rate of return. However, the simplified nature of the model can
lead to conclusions which are net true in general, though true for Walter’s model.

1. Walter’s model of share valuation mixes dividend policy with investment policy of the firm.
The model assumes that the investment opportunities of the firm are financed by retained
earnings only and no external financing debt or equity is used for the purpose when such a
situation exists either the firm’s investment or its dividend policy or both will be sub-optimum.
The wealth of the owners will maximise only when this optimum investment in made.
2. Walter’s model is based on the assumption that r is constant. In fact decreases as more
investment occurs. This reflects the assumption that the most profitable investments are made
first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to
optimise the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly
with the firm’s risk. Thus, the present value of the firm’s income moves inversely with the cost
of capital. By assuming that the discount rate, K is constant, Walter’s model abstracts from the
effect of risk on the value of the firm.

2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.
Assumptions:
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.

3. Modigliani and Miller’s hypothesis:

According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not
affect the wealth of the shareholders. They argue that the value of the firm depends on the firm’s
earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm.

M – M’s hypothesis of irrelevance is based on the following assumptions.

1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.

Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As a
result, the price of each share must adjust so that the rate of return, which is composed of the rate
of dividends and capital gains, on every share will be equal to the discount rate and be identical
for all shares.
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance
in the real world situation. Thus, it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true if the
costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated with
the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k)
should be same whether firm uses the external or internal financing.
If investors have desire to diversify their port folios, the discount rate for external and internal
financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.