Unit 6 dividend policy


Published on

Download Happily !! :)

Published in: Economy & Finance, Business
  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Unit 6 dividend policy

  1. 1. 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 the company. 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 institutions. 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
  2. 2. 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 funds. 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 performance improved. Equity capital has some disadvantages to the firm compared to other sources of finance. They are as follows: 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 ordianry shares. 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
  3. 3. residual earnings, (c) preference shareholers have claims on income and assets prior to ordinary shareholders, and (d) they usually do not have voting rights. 3.4.1 Features 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 call premium. 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
  4. 4. 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 company. 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 shareholders. 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. 3.5 DEBENTURES 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. 3.5.1 Features
  5. 5. 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 instalments. Redemption As indicated earlier, debentures aremostly redeemable; they aregenerally redeemed on maturity. Redeemption of debentures can be accomplished either through a sinking fund or buy-back(call) provision. 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
  6. 6. 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 , 7th and 8th 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 following conditions 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
  7. 7. 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 policy. 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
  8. 8. 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 payment. 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
  9. 9. 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 :
  10. 10. 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 dividends. 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 their monies. 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
  11. 11. 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 years. 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 impact. 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
  12. 12. 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 same. 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.
  13. 13. 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 capital. 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 conditions : 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.
  14. 14. capital. 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 purpose? 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.