1. Neelakshi Saini
Assistant professor (MBA)
Sri Sai Groups of institutes Badhani Pathankot
Neelakshi Saini
Assistant professor (MBA)
Sri Sai college of Engineering and Technology
2. MEANING OF
DIVIDEND
The term dividend refers to that
portion of profit which is
distributed among the
owners/shareholders of the
firm.
3. INTRODUCTION TO DIVIDEND POLICY
The dividend policy of a firm determines what proportion of earnings is paid to
shareholders by way of dividends and what proportion is ploughed back in the
firm for reinvestment purposes. If a firm’s capital budgeting decision is
independent of its dividend policy, a higher dividend payment will call for a
greater dependence on external financing. Thus, the dividend policy has a
bearing on the choice of financing. On the other hand, firm’s capital budgeting
decision is dependent on its dividend decision; a higher dividend payment will
cause shrinkage of its capital budget and vice versa. In such case, the dividend
policy has a bearing on the capital budgeting decision.
4. MEANING OF DIVIDEND POLICY
Dividend policy refers to the policy that the management
formulates in regard to earnings for distribution as dividend
among shareholders. It is not merely concerned with
dividends to be paid in one year, but is concerned with the
continuous course of action to be followed over a period of
several years.
5. FACTORS AFFECTING DIVIDEND
POLICY
1 Stability of Earnings
2. Financing Policy of the Company
3. Liquidity of Funds
4. Dividend
5. Policy of Competitive Concerns
6. Past Dividend Rates
7. Debt Obligations
8. Ability to Borrow
9. Growth Needs of the Company;
6. 1 Stability of earnings is one of the important factors influencing
the dividend policy. If earnings are relatively stable, a firm is in a better
position to predict what its future earnings will be and such companies
are more likely to pay out a higher percentage of its earnings in
dividends than a concern which has a fluctuating earnings.
2. Financing Policy of the Company:
Dividend policy may be affected and influenced by financing policy of the
company. If the company decides to meet its expenses from its earnings,
then it will have to pay less dividend to shareholders. On the other hand, if
the company feels, that outside borrowing is cheaper than internal
financing, then it may decide to pay higher rate of dividend to its
shareholder. Thus, the internal financing policy of the company influences
the dividend policy of the business firm
7. 3. Liquidity of Funds:
The liquidity of funds is an important consideration in dividend decisions.
According to Guthmann and Dougall, although it is customary to speak of
paying dividends ‘out of profits’, a cash dividend only be paid from money in
the bank. The presence of profit is an accounting phenomenon and a common
legal requirement, with the -cash and working capital position is also necessary
in order to judge the ability of the corporation to pay a cash dividend.
Payment of dividend means, a cash outflow, and hence, the greater the cash
position and liquidity of the firm is determined by the firm’s investment and
financing decisions. While the investment decisions determine the rate of asset
expansion and the firm’s needs for funds, the financing decisions determine the
manner of financing
4. Dividend, Policy of Competitive Concerns:
Another factor which influences, is the dividend policy of other competitive
concerns in the market. If the other competing concerns, are paying higher rate of
dividend than this concern, the shareholders may prefer to invest their money in
those concerns rather than in this concern. Hence, every company will have to
decide its dividend policy, by keeping in view the dividend policy of other
competitive concerns in the market.
8. 5. Past Dividend Rates:
If the firm is already existing, the dividend rate may be decided on the basis of
dividends declared in the previous years. It is better for the concern to maintain
stability in the rate of dividend and hence, generally the directors will have to keep
in mind the rate of dividend declared in the past.
6. Debt Obligations:
A firm which has incurred heavy indebtedness, is not in a position to pay higher
dividends to shareholders. Earning retention is very important for such concerns
which are following a programme of substantial debt reduction. On the other hand,
if the company has no debt obligations, it can afford to pay higher rate of dividend.
7. Ability to Borrow:
Every company requires finance both for expansion programmes as well as for
meeting unanticipated expenses. Hence, the companies have to borrow from the
market, well established and large firms have better access to the capital market
than new and small, firms and hence, they can pay higher rate of dividend. The
new companies generally find it difficult to borrow from the market and hence they
cannot afford to pay higher rate of dividend.
9. 8. Growth Needs of the Company:
Another factor which influences the rate of dividend is the growth needs of the
company. In case the company has already expanded considerably, it does not
require funds for further expansions. On the other hand, if the company has
expansion programmes, it would need more money for growth and development.
Thus when money for expansion is not, needed, then it is easy for the company to
declare higher rate of dividend.
9. Profit Rate:
Another important consideration for deciding the dividend is the profit rate of the
firm. The internal profitability rate of the firm provides a basis for comparing the
productivity of retained earnings to the alternative return which could be earned
elsewhere. Thus, alternative investment opportunities also play an important role
in dividend decisions.
10. Legal Requirements:
While declaring dividend, the board of directors will have to consider the legal
restriction. The Indian Companies Act, 1956, prescribes certain guidelines in
respect of declaration and payment of dividends and they are to be strictly
observed by the company for declaring dividends.
10. 11. Policy of Control:
Policy of control is another important factor which influences dividend policy. If
the company feels that no new shareholders should be added, then it will have
to pay less dividends. Generally, it is felt, that new shareholders, can dilute the
existing control of the management over the concern. Hence, if maintenance of
existing control is an important consideration, the rate of dividend may be
lower so that the company can meet its financial requirements from its retained
earnings without issuing additional shares to the public.
12. Corporate Taxation Policy:
Corporate taxes affect the rate of dividends of the concern. High rates of
taxation reduce the residual profits available for distribution to shareholders.
Hence, the rate of dividend is affected. Further, in some circumstances,
government puts dividend tax on distribution of dividends beyond a certain
limit. This may also affect rate of dividend of the concern.
Effect of Trade Cycle:
Trade cycle also influences the dividend policy of the concern. For example,
during the period of inflation, funds generated from depreciation may not be
adequate to replace the assets. Consequently there is a need for retained
earnings in order to preserve the earning power of the firm.
12. Types of dividend
• CASH
DIVIDEND
• STOCK
DIVIDEND
• BOND
DIVIDEND
• PROPERTY
DIVIDEND
13. Cash dividend: If the dividend is paid in the form of cash to the
shareholders, it is called cash dividend. It is paid periodically out of the
business concerns EAIT (Earnings after interest and tax). • Cash
dividends are common and popular types followed by majority of the
business concerns. • Many companies pay dividends in cash.
Sometimes cash dividend may be supplemented by a bonus issue
(stock dividend). • Company should have enough cash when cash
dividend are declared else arrangement should be made to borrow
funds. • If company follows stable dividend policy , it should prepare a
cash budget for coming period , it is relatively difficult to make cash
planning in anticipation of dividend needed.
Bond dividend is also known as script dividend. If the company does
not have sufficient funds to pay cash dividend, the company promises
to pay the shareholder at a future specific date with the help of issue of
bond or notes
14. . Stock dividend • Stock dividend is paid in the form of the company
stock due to raising of more finance. • Under this type, cash is retained
by the business concern. Represented as distribution of shares in
addition to cash dividend to existing shareholders • The shares are
distributed proportionately . Thus, a shareholder retains his
proportionate ownership of the company.
Property dividend • Property dividends are paid in the form of some
assets other than cash. It will distributed under the exceptional
circumstance. This type of dividend is not published in India. • A
company may issue a non-monetary dividend to investors, rather than
making a cash or stock payment. • Record this distribution at the fair
market value of the assets distributed. • Since the fair market value is
likely to vary somewhat from the book value of the assets, the company
will likely record the variance as a gain or loss.
16. Walter’s model:
Professor James E. Walterargues that the choice of
dividend policies almost always affects the value of the
enterprise. According to him the dividend policy
of a firm is based on the relationship between
the internal rate of return (r) earned by it and
the cost of capital or required rate of return
(Ke).
17. Walter’s model is based on the
following assumptions:
1. The firm finances all investment through retained earnings; that is debt or
new equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
All earnings are either distributed as dividend or reinvested internally
immediately.
4. Beginning earnings and dividends never change. The values of the earnings
pershare (E), and the divided per share (D) may be changed in the model to
determine results, but any given values of E and D are assumed to remain
constant forever in determining a given value.
5. The firm has a very long or infinite life.
18. As per this model, the investment decisions and dividend decisions of a
firm are inter related. A firm should retain its earnings if the return on
investment exceeds the cost of capital. Such firms are called Growth
Firms (r > Ke). Such firms should have zero pay-out and should re-
invest their entire earnings. On the other hand, a firm should distribute
its earnings to the shareholder if the internal rate of return is less than
the cost of capital (r < Ke). Such firms are called declining firms.
Such firms should distribute the entire profits i.e. 100 per cent pay-out
ratio. Firms with internal rate of return equal to the cost of capital (r =
Ke) are called Normal Firms. In such firms, the shareholders will be
indifferent whether the firm pays dividends or retain the profits.
19. The formula to determine the market value of
share as suggested by Prof. Walter is as
under
20. Illustration: Santosh Limited earns Rs.5 per share is capitalized at a rate
of 10% and has a rate of return on investments of 18%. According the
Walter's Formula:
(i) What should be the price per share at 25% dividend pay-out ratio?
(ii) Is this optimum pay-out ratio?
21. As per above calculation at 25% dividend pay-out,
the value of share is Rs.80. But, according to
Walter's model, it is not an optimum dividend pay-
out because, in such case where internal rate of
return is more than the cost of capital (r > Ke), he
has suggested zero dividend pay-out
22. llustration:2 The details regarding three companies are given
below :Compute the value of an equity share of each of these companies
applying Walter's formula when dividend pay-out ratio is (a) 0%, (b) 20%,
(c) 40%, (d) 80%, and (e) 100%. Comment on the conclusions drawn
23. Effect of Dividend Policy on Market Price of Shares
24. Criticisms of Walter Model
1) Absence of External Financing: Prof. Walter's main assumption
that financing of investment proposals only by retained earnings and no
external financing is seldom found in real life. Most of the firms meet
their financial requirements by loans or issuing new shares.
(2) Stable Internal Rate of Return: The rate of return earned by the
firm is never stable. Actually, the rate of return changes with the
increase in investments.
(3) Stable Cost of Capital: The assumption of constant cost of capital
is also unrealistic, because the risk complexion of the firm is not always
uniform. Therefore, cost of capital also changes.
25. Gordon model
The Gordon’s Model, given by Myron Gordon, also supports the
doctrine that dividends are relevant to the share prices of a firm. Here
the Dividend Capitalization Model is used to study the effects of
dividend policy on a stock price of the firm.
Gordon’s Model assumes that the investors are risk averse i.e. not
willing to take risks and prefers certain returns to uncertain returns.
Therefore, they put a premium on a certain return and a discount on the
uncertain returns. The investors prefer current dividends to avoid risk;
here the risk is the possibility of not getting the returns from the
investments.
According to the Gordon’s Model, the market value of the share is equal
to the present value of future dividends. It is represented as
26. Formula
P = [E (1-b)] / Ke-br
Where, P = price of a share
E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate
Br = growth rate
27. Assumptions of Gordon’s Model
1. The firm is an all-equity firm; only the retained earnings are
used to finance the investments, no external source of
financing is used.
2. The rate of return (r) and cost of capital (K) are constant.
3. The life of a firm is indefinite.
4. Retention ratio once decided remains constant.
5. Growth rate is constant (g = br)
6. Cost of Capital is greater than br
28. Criticism of Gordon’s Model
1. It is assumed that firm’s investment opportunities are financed only
through the retained earnings and no external financing viz. Debt or
equity is raised. Thus, the investment policy or the dividend policy or
both can be sub-optimal.
2. The Gordon’s Model is only applicable to all equity firms. It is assumed
that the rate of returns is constant, but, however, it decreases with more
and more investments.
3. It is assumed that the cost of capital (K) remains constant but, however,
it is not realistic in the real life situations, as it ignores the business risk,
which has a direct impact on the firm’s value.
