3.2.2 Features of Ordinary Shares
Ordinary share has a number of special features which distinguish it from other securities. These
features generally relate to the rights and claims of ordinary shareholders.
Claim on income Ordinary shareholders have a residual ownership claim. They have a claim to the
residual income, which is, which is earinings available for ordinary shareholders, after paying
expenses, interest charges, taxes and preference dividend, if any. This income may be split into
two parts: dividents and retained earnings. Dividents are immediate cash flows to shareholers.
Retained earnings are reinvested in the business, and shareholders stand to benefit in future in
the form of the firm's enhanced value and earinings power and ultimately enhanced dividend
and capital gain. Thus, residual income is either directly distributed to shareholders in the form of
dividend or indirectly in the form of capital gains on the ordinary shares held by them.
Dividends payable depend on the discretion of the company's board of directors. A company is not
under a legal obligation to distribute dividends out of the available earinigs. Capital gains depend
on future market value of ordinary shares. Thus, an ordinary share is a risky security from the
investor's point of view. Dividends paid on ordinary shares are not tax deductible in the hands of
Claim on assets Ordinary shareholders also have a residual claim on the company's assets in the
case of liquidation. Liquidation can occur on account of business failure or sale of business. Out of
the realised value of assets, first the claims of debt-holders and then preferenceshareholders are
satisfied, and the remaining balance, if any, is paid to ordinary shareholders. In case of liquidation,
the cliams of ordinary shareholders may generally remain unpaid.
Right to control Control in the context of a company means the power to determine its policies.
The board of directors aprroves the company's major policies and decisions while managers
appointed by the board carry out day-to-day operations. Thus, control may be defined as the
power to appoint directors. Ordinary shareholders have the legal power to elect directors on the
board. If the board fails to protect their interests, they can replace directors. Ordinary
shareholders are able to control management of the company through their voting rights and right
to maintain proportionate ownership.
Voting rights Ordinary shareholders are required to vote on a number of importent matters. The
most significant proposals include: election of directors and change in the memorandum of
association. For example, if the company wants to change its authorised share capital or objectives
of business, it requires ordinary shareholder's approval. Directors are elected at the annual
general meeting (AGM) by the mejority votes. Each ordinary share carries one vote. Thus, an
ordinary shareholder has votes equal to the number of shares held by him. Shareholders may vote
in person or by proxy. A proxy gives a designated person right to vote on behalf of a shareholder at
the company's annual general meeting. When management takeovers are threatened, proxy
fights –battles between rival groups for proxy votes. The existing management could continue its
hold on the company and put all efforts to collect proxy votes. The exiting management could
continue its hold on the company with the help of majority shareholders including the financial
3.2 ORDINARY SHARES
Ordinary shares (refered to as common shares in USA) represent the owenship position in a
company. The holders of ordinary shares, called shareholders (or stockholders in USA), are the
legal owners of the company. Ordinary shares are the source of permanent capital since they do
not have a maturity date. For the capitalcontributed by shareholders by purchasing ordinary
shares, they are enetilted for dividends. The amount or rate of dividend is not fixed; the
company's board of directors decidesit. An ordinary share is, therefore, known as a variable
income security. Being the owners of the company, shareholders bear the risk of ownership; they
are entitled to dividends after the income claims of others have been satisfied. Similarly, when the
company is wound up, they can exercise their claims on assets after the claims of other supplies of
capital have been met.
3.2.3 Pros and Cons of Equity Financing
Equity capital is the most importent long-term source of financing. It offers the following
advantages to the company:
Permannet capital Since ordinary shares are not redeemable, the company has no liablity for cash
outflow associated with its redemption. It is a permanent capital, and is available for use as long as
the company goes.
Borrowing base The equity capital increases the company's financial base, and thus its borrowing
limit. Lenders generally lend in proportion to the company's equity capital. By issueing ordinary
shares, the company increases its financial capability. It can borrow when it needs additional
Dividend payment discretion A company is not legally obliged to pay divedend. In times of
financial difficulties, it can reduce or suspend payment of dividend. Thus, it can avoid cash outflow
associated with ordinary shares. In practice, dividend cuts are not very common and frequent. A
company tries to pay dividend regularly. It cuts dividend only when it cannot manage cash to pay
dividends. For example, in 1986 the Reliance Industries Limited experienced a sharp drop in its
profits and had a severe liquidity problem; as a consequence, it had to cut its dividend rate from
50 per cent to 25 percent. The company, however, increased the dividend rate next year when its
Equity capital has some disadvantages to the firm compared to other sources of finance. They are
Cost Shares have a higher cost at least for two reasons: Dividends are not tax deductible as are
interest payments, and flotation costs on ordinary shares are higher than those on debt.
Risk Ordinary shares are riskier from investors' point of view as there is uncertainty regarding
dividend and capital gains. Therefore, they require a relatively higher rate of return. This makes
equity capital as the highest cost source of finance.
Earnings dilution The issue of new ordinary shares dilutes the existing shareholders' earnings per
share if the profits do not increase immediately in proportion to the increase in the number of
Owenership dilution The isuance of new ordinary shares may dilute the ownership and control of
the existing shareholders. While the shareholsers have a pre-emptive right to retain their
proportionate ownership, they may not have funds to invest in additional shares. Dilution of
ownership assumes great significance in the case of closely held companies. The issuance of
ordinary shares can change the ownership.
3.4 PREFERENCE SHARES
Preference share is often considered to be a hybrid security since it has many features of both
ordinary shares and debenture. It is similar to ordianry share in that (a) the non-payment of
dividends does not force the company to insolvency, (b) dividends are not deductible for tax
purposes, and (c) in some cases, it has no fixed maturity date. On the other hand, it is similar to
debenture in that (a) dividend rate is fixed, (b) preference shareholders do not share in the
residual earnings, (c) preference shareholers have claims on income and assets prior to ordinary
shareholders, and (d) they usually do not have voting rights.
Preference share has several features. Some of them are common to all types of preference shares
while others are specific to some.
Claims on income and assets Preference share is a senior security as compared to ordinary share.
It has a prior claim on the company's income in the sense that the company must first pay
preference dividend before that od ordinary share. Thus, in terms of risk, preference share is less
risky than ordenary share. There is a cost involved for the relative safety of preference investment.
Preference shareholders generally do not have voting rights and can not participate in
extraordinary profits earned by the company. However, a company can issue preference share
with voting rights (called participative preference shares).
Fixed dividend The dividend rate is fixed in the case of preference share, and preference dividends
are not tax deductible. The preference dividend rate is expressed as a percentage of the par value.
The amount of preference dividend will thus be equal to the dividend rate multiplied by the par
value. Preference share is called fixed-income security because it provides a consatant income to
investors. The payment of preference dividend is not a legal obligation. Usually, a profitable
company will honour its commitment of paying preference dividend.
Cumulative dividends Most preference shares in India carry a cumulative dividend feature,
requiring that all past unpaid preference dividend be paid before any ordinary dividends are paid.
This feature is a protective device for preference share holders. The preference dividends couldbe
omitted or passed without the cumulative feature. Preference shareholders do not have power to
force company to pay dividends; non-payment of preference dividend also does not result into
insolvency. Since preference share does not have the dividend enforcemant power, the
cumulative feature is necessary to protect the rights of preference shareholders.
Redemption Theoretically both redeemalble and perpetual (irredeemable) prefernce shares can
be issued. Perpetual or irredeemable preference share does not have a maturity date.
Redeemable preference share has a specified maturity. In practice, redeemable preference shares
in India are not often retired in accordance with the stipulation since there are not serious
penalties for violation of redemption feature.
Sinking fund Like in the case of debenture, a sinking fund provision may be created to redeem
preference share. The money set aside for this purpose may be used either to purchase
preference share in the open market or to buy back (call) the preference share. Sinking funds for
preference shares are not common.
Call feature The call feature permits the company to buy back preference shares at a stipulated
buy-back or call price. Call price may be higher than the par value. Usually, it decreases with the
passage of time. The difference between call price and par value of the preference share is called
Participation feature Preference shares may be some cases have particiapation feature which
entitles preference shareholders to participate in extraordinary profit earned by the company. This
means that a preference shareholder may get dividend amount in excess of the fixed dividend.
The formula for determining extra dividend would differ. A company may provide for extra
dividend to preference shareholders equal to the amount of ordinary dividend that is in excess of
the regular preference dividend. Thus if the preference dividend rate is 10 per cent and the
company pays an ordinary dividend of 16 per cent, then preference shareholders will receive extra
dividend at 6 per cent (16 per cent – 10 per cent). Preference shareholders may also be entitled to
participate in the residual assets in the event of liquidation.
Voting rights Preference shareholders ordinarily do not have any voting rights. They may be
entitled to contingent or conditional voting rights. In India, if a preference dividend is outstanding
for two or more years in the case of cumulative preference shares, or the preference dividend is
outstanding for two or more consecutive preceding years or for a period of three or more years in
the preceding six years, preference shareholders can nominate a member on the board of the
Convertibility Preference shares may be convertible or non-convertible. A convertible preference
share allows preference shareholders to convert their preference shares, fully or partly, into
ordinary shares at a specified price during a given period of time. Preference shares, particularly
when the preference dividend rate is low, may sometimes be converted into debentures. For
example, the Andhra Cement converted itspreference shares of Rs 0.33 crore into debentures in
1985. To make preference share attractive, the government of India has introduced convertible
cumulative preference share (CCPS). Unfortunately, companies in India have hardly used this
security to raise funds.
3.4.2 Pros and Cons
Preference share has a number of advantages to the company, which ultimately occur to ordinary
Riskless leverage advantage Preference share provides financial leverage advantages since
preference dividend is a fixed obligation. This advantage occurs without a serious risk of default.
The non-payment of preference dividends does not force the company into insolvency.
Dividend postponablity Preference share provides some financial flexiblity to the company since it
can postpone payment of dividend.
Fixed dividend The preference dividend payments are restricted to the stated amount. Thus
preference shareholders do not participate in excess profits as do the ordinary shareholders.
Limited voting rights Preference shareholders do not have voting rights except in case dividend
arrears exist. Thus the control of ordinary shareholders is preserved.
The following are the limitations of preference shares;
Non-deductibility of dividends The primary diaadvantage of preference shares is that preference
dividend is not tax deductible. Thus it is costlier than debunture.
Commitment to pay dividend Although preference dividend can be omitted, they may have to be
paid because of their cumulative nature. Non-payment of preference dividends can adversely
affect the image of a company, since equity holders cannot be paid any dividends unless
preference shareholders are paid dividends.
A debeture is a long-term promissory note for raising loan capital. The firm promises to pay
interest and principal as stipulated. The purchasers of debentures are called debetureholders. An
alternative form of debenture in India is bond. Mostly public sector companies in India issue
bonds. In USA, the term debenture is generally understood to mean unsecured bond.
A debenture is a long-term, fixed-income, financial security. Debenture holders are the creditors
of the firm. The par value of a debenture is the face value apprearing on the debenture certificate.
Corporate debentures in India are issued in different denominations. The large public sector
companies issue bonds in the denominations of Rs 1,000. Someof the important features of
debentures are discussed below.
Interest rate The interest rate on a debenture is fixed and known. It is called the contractual rate
of interest. It indicates the percentage of the par value of a debenture that will be paid out
annually (or semi-annually or quaterly) in the form of interest. Thus, regardless of what happens
to the market price of a debenture, say, with a 15 per cent interest rate, and a Rs 1,000 par value,
it will pay out Rs 150 annually in interest until maturity. Payment of interest is legally binding on a
company. Debenture interest is tax deductible for computing the company's corporate tax.
However, it is taxable in the hands of a debenture holder as per the income tax rules. However,
public sector companies in India are sometimes allowed by the government to issue bonds with
tax-free interest. That is, the bondholder is not required to pay tax on his bond interest income.
Maturity Debentures are issued for a specific period of time. The maturity of a debenture indicates
the length of time until the company redeems (returns) the par value to debenture-holders and
terminates the debentures. In India, a debenture is typically redeemed afterv7 to 10 years in
Redemption As indicated earlier, debentures aremostly redeemable; they aregenerally redeemed
on maturity. Redeemption of debentures can be accomplished either through a sinking fund or
Sinaking fund A sinking fund is cash set aside periodically for retiring debentures. The fund is
under the control of the trustee who redeems the debentures either by purchasing them in the
market or calling them in an acceptable manner. In some cases, the company itself may handle
the retirement of debentures using the sinking funds. The advantage is that the periodic
retirement of debt through the sinking funds reduces the amount required to redeem the
remaining debt at maturity. Particularly when the firm faces temporary financial difficulty at the
time of debt maturity, the repayment of huge amount of principal could endanger the firm's
financial viablity. The use of the sinking fund eliminates this potential danger.
Buy-back (call) provision Debentures issues include buy-back provision. Buy-back provisions
enable the company to redeem debentures at a specified price before the maturity date. The
back(call) price may be more than the par value of the debenture. This difference is called call or
buy-back premium. In India, it is generally 5 per cent of the par value.
3.5.2 Types of Debentures
Debentures may be straight debentures or convertible debentures. A convertible debenture(CD) is
one which can be converted, fully or partly, into shares after a specified period of time. Thus on
the basis of convertibility, debentures may be classified into three categaries.
Non-convertible debentures (NCDs)
Fully convertible debentures (FCDs)
Partly convertible debentures (PCDs)
Non-convertible debentures (NCDs) NCDs are pure debentures without a feature of conversation.
They are repayable on maturity. The inverstor is entitled for interest and repayment of preincipal.
The ertwhile Industrial Credit and Investment Coporation of India (ICICI) issued debentures for Rs
200 crores fully non-convertible bonds of Rs 1,000 each at 16 per cent of interest, payable half-
yearly. The maturity period was five years. However, the investors had the option to be repaid
fully or partly the pricipal after 3 years after giving due notice to ICICI.
Fully convertible debentures (FCDs) FCDs are converted into shares as per the terms of the issue
with regard to price and time of conversion. The pure FCDs carry interest rates, generally less than
the interest rates on NCDs since they have the attraction feathure of being converted into quity
shares. Recently, companies in India are issuing FCDs with zero rate of interest. For example, Jindal
Iron and Steel Company Limited raised Rs 111.2 each. After 12 months of allotment, each FCD was
convertible into one share of Rs 100-Rs 90 being the premium.
Partly convertible debentures (PCDs) A number of debentures issued by companies in India have
two parts; a convertible part and a non-convertible part. Such debentures are known as partly
convertible debentures (PCDs). The investor has the advantages of both convrtible and non-
convertible debentures blended into one debenture. For example, Proctor and Gamble Limited
(P&G) issued 400,960 PCDs of Rs 200 each to its existing shareholders in July 1991. Each PCD has
two parts; convertible portion of Rs 65 each to be converted into one equity share of Rs 10 each at
a premium of Rs 55 per share at the end of 18 months from the date of allotment and non-
convertible portion of Rs 135 payable in three equal instalments on the expiry of 6th
years from the date of allotment.
3.5.3 Pros and Cons
Debenture has a number of advantages as long-term source of finance:
Less costly It involves less cost to the firm than the equity financing because (a) investors consider
debentures as a relatively less risky investment alternative and therefore, require a lower rate of
return and (b) interest payments are tax deductible.
3.6 FIXED DEPOSITS FROM PUBLIC
There are several modes through which a company can borrow funds for its short term working
capital requirements. This includes borrowing from banks, coporate bodies, individuals, etc. These
borrowings may be secured or unsecured. A company may also obtain fixed deposits from
public/shareholders to meet its short-term fund requirements subject to certain provisions under
the Companies Act, 1956 (The Act).
Pursuant to the provsions of the Act ( Section 58A), the company can invite deposit subject to the
It is in accordance with the prescibed rules.
An advertisment is issued showing the financial position of the company and
The company is not in default in the repayment of any deposit or interest.
3.6.2 Reasons for Fixed Deposits
For its short term requirements, a company may prefer to accept fixed deposits instead of taking
loans from banks depending on the rates of interest being charged. Normally, listed companies
come out with the schemes of 'fixed deposits' as they are better known. Response to such listed
compnies from public is better known. Response to such listed companies from public is better as
compared to unlisted companies.
A non-banking and non-financial company can borrow deposits up to the extent given below:
(i) Up to 25% of the paid-up capital and free reserves of the company from the public and
(ii) Up to 10% of its paid-up capital and free reserves from its shareholders.
Therefore, maximum deposit a company can accept from public/shareholders is 35% of its paid up
capital and free reserves as mentioned above.
If the company is a Government Company, then it can accept or renew deposits from public upto
35% of its paid up capital and free reserves.
Dividend Decision and Policy
Meaning and Significance :
Corporate earnings distributed to shareholders are called dividends. The portion of earnings not
distributed to the shareholders is known as retained earnings. Distribution of dividends to the
shareholders involve outflow of cash. Retained earnings are one of the easiest and cheapest of
financial resources available to the company for expansion and growth. What portion of the
earnings is to distributed by way of dividends and what portion is to be retained is an very
important consideration before the management for formulation of an appropriate dividend
The financial manager is concerned with the following questions in dividend decisions :
1. Should profits be retained in the business for investment decisions?
2. Whether any dividends be paid?
3. How much dividends be paid?
4. When these dividends be paid?
5. In what form the dividend be paid?
A finance manager’s objective for the company’s dividend policy is to maximize owner’s wealth
while providing adequate financial resources for the company. Normally a portion of the business
profits is retained for reinvestment in the business and the remainder is paid out the shareholders
as dividends. The major problem is in the difficulty in deciding what portion of the profit (after
taxes) is to be distributed by way of dividends to the shareholders so as to maximize the wealth
of the shareholders.
If the management decides to retain a larger portion of the profits, the company will get
substantially large amount of funds at cheaper rate and without any obligation to refund the
same. This enables the company to finance its expansion and modernization schemes; thereby
improving the company’s earning capacity, which will facilitate the company to pay out fair
amount of dividends to shareholders regularly and also retain a portion of the increased earnings
for financing further growth requirements, accelerating further the progress of the company. This
will be reflected in the share prices moving up and the total value of the business will tend to
maximize. Although shareholders will have to forego dividends in the short run, they are likely to
be benefited immensely by greater retention in the long run. They will be getting fairly larger
amount of dividends regularly in future when the company’s earnings will improve considerably.
Thus, larger retention of earnings is one of the best means of the firm’s growth and prosperity.
In a sharper contrast to the above, the management may decide to distribute considerable
portion of earnings to pay out dividend at fairly higher rate so as to maintain confidence of
existing shareholders and to tempt potential investors to invest in securities of the company.
Generally, shareholders have strong preference for dividend income because of uncertainty in
future return. To them dividend is tangible evidence of profitability of the firm. Shareholders are,
therefore, attracted to companies with high dividends because such companies in their view are
considered highly successful and efficient. Accordingly, price of shares of the company will tend to
soar resulting in maximization of wealth of the company and its shareholders.
Hence, from the above it follows that both growth and dividends are desirable; but they
are in conflict. Higher dividend amounts to less provision of funds for growth and modernization
purpose which may in turn hamper growth rate in earnings and share prices. Retention of larger
earnings leaves a merger amount of funds for dividend payments to which shareholders may react
strongly causing setback to share prices. Therefore, the management of the company is in a
dilemma to strike a satisfactory compromise between dividend payment and retention.
Therefore, the important task before the management of the company is to formulate its
dividend policy in such a manner as to maximize the share price. An erroneous dividend policy
may land the company in financial predicament and unbalanced capital structure. Progress of the
company may be hampered owing to dearth of resources which may result in fall in earnings per
share. Stock market is very likely to react to this development adversely and share prices may tend
to fall leading to decline in the total value of the firm. Therefore, the management of the company
has to exercise care and prudence in formulating an appropriate dividend policy.
Factors Influencing Dividend Policy
The following are the major factors influencing the dividend policy of a company :
1. Stability of Earnings : if the earnings of a company are unstable, it would be difficult to
predict the dividend of the company. With stable earnings, the dividend rate can be
predicted with more certainty. Usually, the concerns dealing in luxury goods do have a
fluctuating income; whereas those concerns dealing in necessities have a stable and
regular income. Prof. Prasanna Chandra in his studies on Valuation of Equity Share has
revealed that companies are reluctant to frequently change the dividend rates (especially
be a downward change). Stability of dividend is considered as a virtue; which can be
achieved only when the earnings are themselves stable. Thus a stability of income is an
important factor that has a great influence on the dividend policy.
2. Financing policy of the Company : Some companies may decide to retain a larger portion
of its earnings and distribute as dividends a smaller portion. While other companies may
decide to retain a smaller portion and distribute a larger portion by way of dividends.
When companies retain a larger portion; it has to ensure the retained earnings which are
employed in the business at least fetch a return higher than what would have been
possible had the shareholders invested the dividend income elsewhere. The financing
policy adopted by the company of a large extent has a considerable influence on the
dividend policy. When a company has opportunity to invest in projects that promise a rate
of return which is higher than the capitalization rate of shareholders, it will be appropriate
to retain more funds than to distribute the same by way of dividend. This point is brought
out by Walter’s model which indicates that whenever the internal productivity of retained
earnings is higher than the market capitalization rate, it will be appropriate to pay out
less as dividend and retain more for reinvestment. This has the effect of increasing the
market price of the shares.
3. Liquidity of Funds : Payment of dividend means a cash outflow. Even though a company
has earned considerable profits; the same would be trapped up in various business assets
and not readily available in the form of cash and bank balance or other liquid assets. This
may also happen when a company has invested the funds in business expansion or new
investment opportunities. In such a case, the company would not be in a position to pay
dividend immediately. Hence the availability of cash resources determines the dividend
4. Debt obligations : A business concern may be having heavy debt obligations and would
therefore be more concerned in retiring such liabilities first. In such a case, the company.
Would not be in position to spare any cash resources for payment of dividend or may
decide to pay a lower rate of dividend according to the availability of cash resources. A
company having no debt obligations can afford to pay a higher rate of dividend. When debt
capital is available at high rates of interest or under restrictive covenants, companies have
a tendency to rely more on internal sources by reducing dividends.
5. The growth rate of the company : A company may be growing at a fast rate; in which case
there would be heavy demand on the cash resources of the company needed to finance
additional level of activity. There would be more demand for working capital. In such cases
shortage of funds would not permit a company to pay a higher rate dividend. Whereas
when a company has already expanded considerably and any further expansion would not
yield the desired return; it may decide to pay a higher rate of dividend.
6. Rate of profit generation : The rate of which profits are generated is a crucial factor in
determining the dividend distribution. If the rate of generation of profits more than what is
normally anticipated, then there may be tendency to distribute dividends. Whereas the
reverse would be the situation in case of lower rate of generation of profits. This may be
mainly contributed because of the efficiency or inefficiency with which business operations
would be conducted.
7. Taxation : When tax rates on capital gains are lower that personal income-tax rates,
shareholders belonging to high personal income tax brackets may have a tendency to
prefer a low dividend pay out policy. This would enable reduction in the incidence of
personal taxation; when less income is received in the form of dividend income and more
income is received in form of capital gains. To prevent this practice, government has
previously imposed additional taxation on undistributed profits in case of companies. Now
as the present income tax law stands in India, the dividend income is tax free in the hands
of the shareholders, while the burden of taxation on dividends has been passed on to the
corporate. Hence there is more attraction in receiving dividend income rather than having
to be taxed on capital gains.
Dividend Pay out and Stability of Dividends
The objective of any business concern being maximization of shareholders wealth; the
management is concerned in framing a suitable dividend policy which will enable to achieve this
objective. This would be practically difficult to arrive at an optimal dividend policy suitable in all
conditions and to all firms. The management should aim at minimization of the cost of capital and
maximizing the market price of the share. Hence it becomes necessary to determine as to what
portion of profits should be retained in the business and what portion of profits should be
distributed by way of dividends in achieving this objective. In framing a suitable dividend policy it
is necessary to bear in mind that all the profits should be distributed by way of dividends. While at
the same time, retention of earnings as a very important source of finance cannot be overlooked.
Yet, keeping in view the above constraints, the company is expected to frame a suitable dividend
policy to achieve the objective of shareholders wealth maximization.
The following two decisions are vital in deciding dividend policy :
(a) Dividend Payout Ratio
(b) Stability of Dividends
Apart from the above, the legal procedure and aspects requires due consideration.
Dividend Payout Ratio :
Dividend payout ratio is the ratio of amount of dividend to the profit after tax available for
distribution to equity shareholders. It is the percentage of the after tax profits to be distributed by
way of dividends to the equity shareholders. The profits which are not distributed are retained
profits available for financing the business activities of the company. The decision regarding D/P
ratio requires careful consideration weighing the following factors :
1. Liquidity position : Liquidity refers to the availability of cash for the purpose of paying
dividends. The firm’s liquidity position is independent of its profits earned. Good profits
does not necessarily mean good liquidity. As it is possible, that a large of profits may be
invested or locked in various assets of the firm or used in retiring the liabilities. Hence if the
liquidity position is not favorable; the firm may refrain from declaring any dividend for
payment, even though the profits after tax for the year shows good figure.
2. Plans for future expansion and growth : If the firm has future plans for further expansion
and growth; it would retain considerable profits for the purpose; as the retained profits
sources for financing. This would strengthen the company’s financial position and enhance
its earnings in future. This in turn would help in generating more funds in future.
3. Dilution of management control : The company going in for expansion and growth, may
prefer to raise funds through new issue of shares. This would lead to increase in the
shareholders leading to dilution of control of the management. To avoid such a situation,
the company may prefer a low payout policy. In case of borrowing from financial institution
and banks, there would be conditions imposed by the financing agencies which would put
restrictions on their working. The financial institutions normally nominate their
representative as director on the board.
Consequences of Low Payout Policy :
1. Low payout policy may dishearten the shareholders who are interested in current
2. It may lead to accumulation of large surpluses which requires careful planning and
foresight for good investments.
3. If the cash resources are invested in bad project, the shareholders would be deprived of
4. There would be temptation on the part of management to invest in projects even if the
returns are below the normal rate of investment.
5. Accumulations of cash resources may not provide necessary inducement to the
management to exploit better opportunities.
Consequence of High out Policy :
1. The firm may miss the opportunities which would have earned better returns and thereby
enabled higher returns to the shareholders in future; had the funds been retained and
invested in such profitable projects.
2. It provides short term returns to the shareholders at the cost of depriving in long term
much higher returns to them.
3. Liquidity position could be adversely affected impairing their business operations.
4. Growth and expansion of the business would be adversely affected.
5. The cheapest source of available finance is not taken advantage of by the firm; thereby
raising their cost of capital and squeezing their profit margins.
Stability of Dividends
It is generally believed that the shareholders favor a stable dividend, increasing gradually in
steady manner over the years. Shares of such companies command a higher market price. A
company paying a stable and increasing steady dividend projects a picture of good growth and
confidence in the minds of the shareholders; as they are assured of receiving a definite dividend.
The payment of dividends depends upon the availability of profits. These profits depending upon
the volatile market and business conditions, fluctuate from year to year. In such circumstances it
becomes difficult to achieve consistency in dividend payments; unless sufficient and adequate
reserves are built up during good profits years, to enable the company to fall back upon in lean
Significance of Stability of Dividends
Stability of dividend policy is suggested in view of the following :
1. Regularity in the amount and payment of dividend build up confidence in the minds of the
investors regarding the financial soundness of the company.
2. Investors prefer current income regularly rather than future expected income. This is true
for investors such as aged, retired person and women who are interested in current
income to meet their living expenses.
3. Stable dividend policy brings about stability in the market prices of the shares.
4. Investors would be interested in holding such shares as long term investment. It helps in
building goodwill and loyalty towards the company. This facilitates in raising additional
finance more easily as new issues would be readily and promptly responded.
5. The ownership base is broadened as small investors would be interested in investing in
such stable income shares.
6. Since the control is widespread; therefore the chances of concentrating control in a few
hands are curbed. This affords projection from vested interests.
7. Market response would respond favorably whenever a new issue of shares, preference or
debentures Is floated in the market. The regularity of dividend is sufficient assurance to the
investors regarding the safety of their investment and good working of the company.
Kinds of Dividends
In India only two types of dividend are prevalent :
a) Cash dividend
b) Scrip dividend i.e. Bonus shares.
Dividend Policies According to Stability
From the point of view of stability, the dividend policy can take the following forms :
1. Constant DP Ratio : Constant DP ratio implies that every year a constant or fixed
percentage of the after tax profits will be paid as dividends. This means that if profits are
high, then a high amount of profits will be paid by way of dividends; which means that the
dividend rate per share would be high. Likewise, in case of low profits, low amount of
profits would be distributed by way of dividends. In absence of profits in any year, no
dividend would be paid. In other words, high profits would mean the quantum of profits to
be distributed would be very high; whereas in case of low profits, the quantum of profits to
be distributed by way of dividends would be low. Fixed percentage of after tax profits to be
distributed by way of dividend is maintained every year. This would lead to erratic
fluctuations in the earnings per share. This type of policy is not favored by the shareholders
who would lose confidence since there is no certainty regarding payment of dividends.
This policy may be good in case the business is growing every year and so also the earnings
are increasing every year. In case of drop in earnings in any year, it will have an adverse
2. Constant dividend per share : According to this policy, a constant dividend per share will
be paid every year irrespective of fluctuations in earnings. However, in case of losses and
inadequate previous year’s profits / reserves, it would not be able to pay any dividend
legally. The shareholders are in receipt of regular and constant dividend ever year. They
are certain about the dividend they are going to get every year. However, the investors
would not have any enthusiasm in buying the shares since there is no growth in the
dividend. As a result the market price will not be able to move up and will rule at a
constant level. In lean years, the company will face the problem of meeting the
commitment unless it has built up sufficient reserves.
3. Steadily increasing Dividend : Many companies do follow a policy of regularly paying
dividend at a lower rate; however steadily increasing the rate over the years. The strategy
followed by many companies is to build up sufficient reserves in initial years and plough
back a considerable amount of profits without payment of any dividend; unless they are
confident that once paid, they would be able to maintain the dividend rate for a fairly long
period in spite of setback in profits. This policy has considerable positive effects on the
minds of the shareholders. Shareholders generally prefer a steadily growing dividend rate.
The market price of shares of such companies do show an upward trend.
4. Constant and steady dividend plus extra : According to this policy, companies maintain a
constant dividend with steady increase. However, extra dividend along with the normal
constant dividend will be paid accordingly due to the higher earnings of the company.
Although a constant rate is maintained, this rate is enhanced by adding an extra amount
depending upon the earnings of the company. If there are no higher earnings, then the
constant rate will be paid. In case of higher earnings in any particular year, the dividend
rate is increased accordingly. The word ‘extra’ indicates that it is something more than the
normal and cannot be expected every year. Extra dividend means that it would be paid
only when additional earnings have accrued to the company. From the point of view of
management, this dividend policy would be flexible, as they can alter the dividend rate
subject to the earnings of the company. If extra dividend is followed as a regular feature; it
would become a matter of regular policy. In which case any deviation would be
unwelcome; as the shareholders have already assumed that the extra dividend would be
paid as a regular annual dividend. Therefore, it is better to preserve the meaning of the
work ‘extra’, and pay the same only when higher earnings and conditions support the
Dividends – Legal Aspects
While designing a dividend policy, the legal considerations assume great importance. The
following legal aspects are required to be attended before payment of dividends to shareholders :
The provisions regarding the procedure and payment of dividends are contained in Section
205, 205A, 206A and 207 of the Companies Act, 1956, and articles 85 to 94 of the Table A of the
Companies Act, 1956. These provisions are summarized as follows :
1. A company can pay dividends only if sufficient provisions have been made for redemption
of redeemable preference shares, if any in accordance with the provisions of the Act.
2. A company is also required to ensure that sufficient depreciation has been provided as per
requirements of Schedule XII annexed to the Companies Act, 1956.
3. All dividends must be paid in cash (other than the bonus shares issue which is issued by
capitalizing the profits.)
4. The cash dividend can be paid either as
a) Final dividend : this dividend can be made on recommendation of the Board of Directors
but subject to the approval of the shareholders in the Annual General Meeting of the
company. There must be due compliance of the procedural requirements as per the listing
agreement with the stock exchange.
b) Interim dividend : this dividend is paid between two Annual General Meeting after passing
a resolution by the Board of Directors. The Board may pay such dividend based on the
financial performance of the company during the year before the accounts are finalized for
the relevant year. However, this is subject to the clauses contained in the Articles of the
company permitting such an action.
5. Dividend is payable only out the current year’s revenue profits of the company. However,
dividend can be paid out of the accumulated profits of the previous years in case of
inadequacy or absence of current year’s profits subject the rules mentioned below.
The Central Government has prescribed rules as contained in the Companies (Declaration of
Dividend out of Reserves) Rules, 1975.
The rules provides that in the event of inadequacy or in the absence of profits in any year,
dividend may be declared by a company for that year out of the accumulated profits earned by
it in the previous years and transferred by it to the reserves, subject to the conditions that :
a) The rate of dividend shall not exceed the average of the rates at which dividend was
declared by it in the five years immediately preceding that year or 10 per cent of its paid up
capital whichever is less;
b) The total amount to be drawn from the accumulated profits earned in previous years and
transferred to the reserves shall not exceed an amount equal to one-tenth of the sum of its
paid up capital and free reserves and the amount so drawn shall first be utilized to set off
the losses in the financial year before any dividend in respect of preference or equity
shares in declared; and
c) The balance of reserves after such draw shall not fall below 15 per cent of its paid up
For the purposes of the rules, profit earned by a company in previous years and transferred by
it to the reserves shall mean the total amount of net profits after tax, transferred to reserves as at
the beginning of the year for which the dividend is to be declared; and in computing the said
amount, the appropriations out of the amount transferred from the Development Reserve (at the
expiry of the period specified under the Income Tax Act, 1961) shall be included and all items of
capital reserves including reserves created by revaluation of assets shall be excluded.
6. Further that dividend is payable out of revenue profits only, however, in certain cases
dividend can be paid out of capital profits also subject to the fulfillment of the following
a) Such capital profits are realized in cash.
b) The Articles of Association of the company permit such payment.
c) Such capital profits exist after revaluation of other assets.
Further at the time of payment of dividend out of current year’s revenue profits, the company
has to ensure compliance with relevant rules in this regard.
Section 205 (2A) of the Companies Act, 1956 provides that before declaration and payment of
dividend out of current year’s profit, a company is required to transfer such percentage of its
profits for the current year to reserves, not exceeding 10 per cent as may be prescribed. The
Central Government has prescribed such percentage by framing the Companies (Transfer of Profits
to Reserves) Rules, 1975. Rule 2 provides that no dividend shall be declared or paid by a company
for any financial year out its profits for that year arrived at after providing for depreciation in
accordance with provisions of sub section (2) of Section 205 of the Act except after the transfer to
reserves of the company of a percentage of its profits for that year as specified below :
When the dividend proposed. Amount to be transferred to the
Reserves much not be less than
Exceeds 10% but not 12.5% of the Paid up 2.5% of the current year profits.
Exceeds 12.5% but not 15% of the Paid up capital 5% of the current year profits.
Exceeds 15% but not 20% of the Paid up capital 7.5% of the current year profits.
Exceeds 20% of the Paid up capital 10% of the current year profits.
When the proposed dividend is exactly 10% or less of the paid up capital of the company, it is
not obligatory to transfer any portion of the profits to the reserves.
7. The dividends once declared at the annual general meeting of the company must be paid
within 42 day of the declaration. If not, then within 7 days from the date of expiry of the
said period of 42 days, the company must deposit the unpaid dividends in a separate bank
account to be opened by the company in s Scheduled Bank, to be called “Unpaid Dividend
Account of….. Ltd.”. If the money remains unpaid / unclaimed in this account for a period
of 7 years from the date of transfer, then such money shall be transferred by the company
to the Investor Education and Protection Fund.
Questions and Problems
1. What do you understand by ‘Dividend’? What is its significance?
2. What is a ‘Dividend Policy’? State the various factors affecting Dividend Policies?
3. What do you understand by Dividend Payout’? What factors are to be considered for the
4. What is a ‘Dividend Payout Policy’? What are the consequences of ‘Low Payment Policy
and ‘High Payout Policy?
5. What is the significance of Dividend Stability?
6. How dividend policies are classified according to stability?
7. What are the legal considerations for payment of dividend?
8. Write short note on
a) Dividend Payout Policy
b) Stability of Dividend
c) Constant D/P Ratio Policy
d) Constant Dividend Policy
e) Transfers to Reserves on Proposed Dividends.