2. Dividend Policy
Meaning of Dividend
A dividend is a share of profits and retained earnings that a company pays
out to its shareholders. When a company generates a profit and accumulates
retained earnings, those earnings can be either reinvested in the business or
paid out to shareholders as a dividend.
A dividend is nothing but the return declared to the equity shareholders
through the distribution of a portion of profits earned by the
organization. Types of dividend
3. 1.Cash Dividend: It is one of the most common types of dividend paid in
cash. The shareholders announce the amount to be disbursed among the
shareholder on the “date of declaration.” Then on the “date of record”, the
amount is assigned to the shareholders and finally, the payments are made
on the “date of payment”. The companies should have an adequate
retained earnings and enough cash balance to pay the shareholders in cash.
2.Scrip Dividend: Under this form, a company issues the transferable
promissory note to the shareholders, wherein it confirms the payment of
dividend on the future date.A scrip dividend has shorter maturity periods
and may or may not bear any interest. These types of dividend are issued
when a company does not have enough liquidity and require some time to
convert its current assets into cash.
3.Bond Dividend: The Bond Dividends are similar to the scrip dividends,
but the only difference is that they carry longer maturity period and bears
interest.
TYPES OF DIVIDEND
4. 4.Stock Dividend/ Bonus Shares: These types of dividend are
issued when a company lacks operating cash, but still issues, the
common stock to the shareholders to keep them happy.The
shareholders get the additional shares in proportion to the shares
already held by them and don’t have to pay extra for these bonus
shares. Despite an increase in the number of outstanding shares of
the firm, the issue of bonus shares has a favorable psychological
effect on the investors.
5.Property Dividend: These dividends are paid in the form of a
property rather than in cash. In case, a company lacks the operating
cash; then non-monetary dividends are paid to the investors.The
property dividends can be in any form: inventory, asset, vehicle,
real estate, etc. The companies record the property given as a
dividend at a fair market value, as it may vary from the book value
and then record the difference as a gain or loss.
5.Liquidating Dividend: When the board of directors decides to
pay back the original capital contributed by the equity shareholders
as dividends, is called as a liquidating dividend. These are usually
paid at the time of winding up of the operations of the firm or at the
time of final closure.
Types of dividend
5. DIVIDEND POLICY
Meaning of Dividend POLICY
A company’s dividend policy dictates the amount of
dividends paid out by the company to its shareholders and
the frequency with which the dividends are paid out.
When a company makes a profit, they need to make a
decision on what to do with it. They can either retain the
profits in the company (retained earnings on the balance
sheet), or they can distribute the money to shareholders in
the form of dividends.
6. Types of Dividend Policy
1. Generous Dividend Policy : Firms normally have a
strong shareholders orientation. This dividend policy,
reward shareholders generously by stepping up total
dividend payment over time.
2. Erratic Dividend Policy : Firms which follow this
dividend policy, do not bother about the welfare of
equity shareholders.
3. Stable Dividend Policy : Firms which adopt this
dividend policy pay a fixed amount of dividends
regularly irrespective of fluctuations in earnings year
after year.
7. These dividend decisions of an organization are
dependent upon the following determinants:
FACTORS AFFECTING DIVIDEND POLICY
8. FACTORS …
Funds Liquidity: It should be framed in consideration of retaining adequate working capital
and surplus funds for the uninterrupted business functioning.
Past Dividend Rates: There should be a steady rate of return on dividends to maintain
stability; therefore previous year’s allowed return is given due consideration.
Earnings Stability: When the earnings of the company are stable and show profitability, the
company should provide dividends accordingly.
Debt Obligations: The organization which has leveraged funds through debts need to pay
interest on borrowed funds. Therefore, such companies cannot pay a fair dividend to its
shareholders.
Investment Opportunities: One of the significant factors of dividend policy decision making
is determining the future investment needs and maintaining sufficient surplus funds for any
further project.
Control Policy: When the company does not want to increase the shareholders’ control over
the organization, it tries to portray the investment to be unattractive, by giving out fewer
dividends.
Shareholders’ Expectations: The investment objectives and intentions of the shareholders
determine their dividend expectations. Some shareholders consider dividends as a regular
income, while the others seek for capital gain or value appraisal.
Nature and Size of Organization: Huge entities have a high capital requirement for
expansion, diversification or other projects. Also, some business may require enormous funds
for working capital and other entities require the same for fixed assets. All this impacts the
dividend policy of the company.
Company’s Financial Policy: If the company’s financial policy is to raise funds through
equity, it will pay higher dividends. On the contrary, if it functions more on leveraged funds,
9. FACTORS …
Impact of Trade Cycle: During inflation or when the organization
lacks adequate funds for business expansion, the company is unable to
provide handsome dividends.
Borrowings Ability: The company’s with high goodwill has excellent
credibility in the capital as well as financial markets. With a better
borrowing capability, the organization can give decent dividends to the
shareholders.
Legal Restrictions: In India, the Companies Act 1956 legally abide the
organizations to pay dividends to the shareholders; thus, resulting in
higher goodwill.
Corporate Taxation Policy: If the organization has to pay substantial
corporate tax or dividend tax, it would be left with little profit to pay
out as dividends.
Government Policy: If the government intervenes a particular
industry and restricts the issue of shares or debentures, the company’s
growth and dividend policy also gets affected.
Divisible Profit: The last but a crucial factor is the company’s
profitability itself. If the organization fails to generate enough profit, it
won’t be able to give out decent dividends to the shareholders.
10. Develop Shareholders’ Trust: When the company has a constant net earnings percentage, it secures
a stable market value and pays suitable dividends. The shareholders also feel confident about their
investment decision, in such an organization.
Influence Institutional Investors: A fair policy means a strong reputation in the financial market.
Thus, the company’s strong market position attracts organizational investors who tend to leverage a
higher sum to the company.
Future Prospects: The fund adequacy for next project undertaking and investment opportunities is
planned, decides its dividend policy such that to avoid illiquidity.
Equity Evaluation: The value of stocks is usually determined through its dividend policy since it
signifies the organizational growth and efficiency.
Market Value Stability of Shares: A suitable dividend policy means satisfied investors, who would
always prefer to hold the shares for the long term. This leads to stability and a positive impact on the
stocks’ market value.
Market for Preference Shares and Debentures: A company with the proficient dividend policy
may also borrow funds by issuing preference shares and debentures in the market, along with equity
shares.
Degree of Control: It helps the organization to exercise proper control over business finance. Since,
the company may land up with a shortage of funds for future opportunities, if the company
distributes maximum profit as dividends.
Raising of Surplus Funds: It also creates organizational goodwill and image in the market because
of which the company becomes capable of raising additional capital.
Tax Advantage: The tax rates are less on the qualified dividends, which are received as a capital gain
when compared to the percentage of income tax charged.
Importance of Dividend Policy
11. Dividend Theories
Some of the major different theories of dividend in
financial management are as follows: 1. Walter’s model
2. Gordon’s model 3. Modigliani and Miller’s hypothesis.
On the relationship between dividend and the value of the
firm different theories have been advanced. They are as
follows:
Walter’s model:
Professor James E. Walterargues that the choice of
dividend policies almost always affects the value of the
enterprise. His model shows clearly the importance of the
relationship between the firm’s internal rate of return (r)
and its cost of capital (k) in determining the dividend
policy that will maximise the wealth of shareholders.
12. 1.Walter’s formula
The following formula can be applied to
determine the market price per share under
walter’s , model:
Market price per per share (P)= D+r/k *(E-D)/K
When, D = Dividend per shares
r = Rate of return on investment by firm
k = Cost of capital
E = Earnings per share
13. 2.Gordon’s Model
The Gordon’s theory on dividend policy states that the company’s divided
payout policy and the relationship between its rate of return (r) and the cost of
capital (k) influence the market price per share of the company.
Market value per per share (P)= D/k/g (or) E(L-b)/K-br
When, D = Dividend per shares
r = Rate of return on investment by firm
k = Cost of capital
E = Earnings per share
g = growth rate = br
b = Retention ratio
r = Rate of return
14. IMPLICATIONS OF GORDON’S MODEL
Gordon’s model believes that the dividend policy impacts the company in
various scenarios as follows:
GROWTH FIRM
A growth firm’s internal rate of return (r) > cost of capital (k). It benefits
the shareholders more if the company reinvests the dividends rather than
distributing it. So, the optimum payout ratio for growth firms is zero.
NORMAL FIRM
A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does
not make any difference if the company reinvested the dividends or distributed
to its shareholders. So, there is no optimum dividend payout ratio for normal
firms.
However, Gordon revised this theory later and stated that the dividend policy
of the firm impacts the market value even when r=k. Investors will always
prefer a share where more current dividends are paid.
DECLINING FIRM
The internal rate of return (r) < cost of the capital (k) in the declining firms.
The shareholders are benefitted more if the dividends are distributed rather
than reinvested. So, the optimum dividend payout ratio for declining firms is
100%.
15. Modigliani-Miller Hypothesis(M.M.Model)
Modigliani –Miller argue that value of a firm is determined by its earnings
potentiality and investment pattern and not by dividend distribution.
According to them, the dividend decision is irrelevant and it does not affect
the market value of equity shares, because the increase in wealth of
shareholders resulting from dividend payments will be offset subsequently
when additional share capital is raised. If the additional capital is raised in
order to meet the funds requirement, it will dilute the existing share capital
which will reduce the share value to the original position
Determination of Market price of share
po = Present value of Dividends received + Market price of the share at ht
end of the Period.
po = D1/1+Ke +P1/1+ke = D1+P1/1+Ke
the market price of the share at the end of the period(P1) can be ascertained
as followsP1 = po (1+Ke)-D1 Where,
P1 = Market price per share at the end of the period
po = Market price per share at the beginning of the period
ke = Cost of equity capital D1 = Divedend per share at the end of the period
16. Review Questions
Section-A
1. What do you mean by dividend?
2. What is meant by dividend policy?
3. Discuss the different types of dividend.
4. Explain the factors that influence the dividend
policy of a firm.
5. Describe the different types of dividend policy.
6. Write a short note on stable dividend policy.
7. Discuss Walter model of share valuation vis-à-vis
dividend policy.
8. Explain Gordon’s model.
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