Module 6
Dividend Policy
Contents
• Meaning and Importance of Dividend Policy
• Factors Affecting an Entity‘s Dividend Decision,
• Overview of Dividend Policy Theories and Approaches,
• Gordon‘s Approach,
• Walter‘s Approach ,
• Modigliani-Miller Approach.
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.
What is a Dividend?
• A dividend is the share of profits that is distributed to shareholders in the
company and the return that shareholders receive for their investment in
the company.
• The company’s management must use the profits to satisfy its various
stakeholders, but equity shareholders are given first preference as they face
the highest amount of risk in the company.
• A few examples of dividends include:
• 1. Cash dividend
A dividend that is paid out in cash and will reduce the cash reserves of a company.
• 2. Bonus shares
Bonus shares refer to shares in the company are distributed to shareholders at no cost.
It is usually done in addition to a cash dividend, not in place of it.
Examples of Dividend Policies
• The dividend policy used by a company can affect the value of the enterprise.
• The policy chosen must align with the company’s goals and maximize its
value for its shareholders.
• While the shareholders are the owners of the company, it is the board of
directors who make the call on whether profits will be distributed or retained.
• The directors need to take a lot of factors into consideration when making this
decision, such as the growth prospects of the company and future projects.
• There are various dividend policies a company can follow such as:
• 1. Regular dividend policy
• 2. Stable dividend policy
• 3. Irregular dividend policy
• 4. No dividend policy
1. Regular dividend policy
• Under the regular dividend policy, the company pays out dividends to its
shareholders every year.
• If the company makes abnormal profits (very high profits), the excess
profits will not be distributed to the shareholders but are withheld by the
company as retained earnings.
• If the company makes a loss, the shareholders will still be paid a dividend
under the policy.
• The regular dividend policy is used by companies with a steady cash flow
and stable earnings.
• Companies that pay out dividends this way are considered low-risk
investments because while the dividend payments are regular, they may
not be very high.
2. Stable dividend policy
• Under the stable dividend policy, the percentage of profits paid out as
dividends is fixed.
• For example, if a company sets the payout rate at 6%, it is the percentage
of profits that will be paid out regardless of the amount of profits earned
for the financial year.
• Whether a company makes $1 million or $100,000, a fixed dividend will
be paid out.
• Investing in a company that follows such a policy is risky for investors as
the amount of dividends fluctuates with the level of profits.
• Shareholders face a lot of uncertainty as they are not sure of the exact
dividend they will receive.
3. Irregular dividend policy
• Under the irregular dividend policy, the company is under no obligation
to pay its shareholders and the board of directors can decide what to do
with the profits.
• If they a make an abnormal profit in a certain year, they can decide to
distribute it to the shareholders or not pay out any dividends at all and
instead keep the profits for business expansion and future projects.
• The irregular dividend policy is used by companies that do not enjoy a
steady cash flow or lack liquidity.
• Investors who invest in a company that follows the policy face very high
risks as there is a possibility of not receiving any dividends during the
financial year.
4. No dividend policy
• Under the no dividend policy, the company doesn’t distribute
dividends to shareholders.
• It is because any profits earned is retained and reinvested into the
business for future growth.
• Companies that don’t give out dividends are constantly growing and
expanding, and shareholders invest in them because the value of the
company stock appreciates.
• For the investor, the share price appreciation is more valuable than a
dividend payout.
Factors Affecting Dividend Policy
• Management, working with the board of directors, must determine the best uses
for a company’s cash. From a high level, a company has 2 options for its cash:
• Retain it
• Pay it to shareholders
• If they decide to retain it, they have several more options to consider. Specifically,
they can
• Increase cash reserves or other liquid investments
• Reinvest back into the business
• Acquire another company
• Pay off debt
• Buyback shares of their stock
• All of these competing options for the use of cash are factors affecting dividend
policy.
• For example, a company may have large amounts of debt. Furthermore, its debt
Factors Affecting Dividend Policy
• Amount of Earnings
Dividends are paid out of current and past earnings. Thus, earnings is a major
determinant of dividend decision.
• Stability in Earnings
A company having higher and stable earnings can declare higher dividends than
a company with lower and unstable earnings.
• Stability of Dividends
Generally, companies try to stabilize dividends per share. A steady dividend is
given each year. A change is only made, if the company’s earning potential has
gone up and not just the earnings of the current year.
• Growth Opportunities
Companies having good growth opportunities retain more money out of their
earnings so as to finance the required investment. The dividend declared in
growth companies is, therefore, smaller than that in the non-growth companies. .
Factors Affecting Dividend Policy
• Cash Flow Position
Dividend involves an outflow of cash. Availability of enough cash is necessary for payment
or declaration of dividends.
• Shareholders’ Preference
While declaring dividends, management must keep in mind the preferences of the
shareholders. Some shareholder& general desire that at least a certain amount is paid as
dividend. The companies should consider the preferences of such shareholders .
• Taxation Policy
If the tax on dividends is higher, it is better to pay less by way of dividends. But if the tax
rates are lower, higher dividends may be declared. This is because as per the current taxation
policy, a dividend distribution tax is levied on companies. However, shareholders prefer
higher dividends, as dividends are tax free in the hands of shareholders.
• Stock Market Reaction
Generally, an increase in dividends has a positive impact on stock market, whereas, a
decrease or no increase may have a negative impact on stock market. Thus, while deciding
on dividends, this should be kept in mind.
Factors Affecting Dividend Policy
• Access to Capital Market
Large and reputed companies generally have easy access to the capital market
and, therefore, may depend less on retained earnings to finance their growth.
These companies tend to pay higher dividends than the smaller companies.
• Legal Constraints
Certain provisions of the Companies Act, place restrictions on payouts as
dividend. Such provisions must be adhered to, while declaring the dividend.
• Contractual Constraints
While granting loans to a company, sometimes, the lender may impose certain
restrictions on the payment of dividends in future. The companies are
required to ensure that the dividend payout does not violate the terms of the
loan agreement in this regard.
Types of Dividend
1. Equity Dividend:
• The dividend paid on equity shares is called Equity Dividend. The rate of equity dividend
is set (recommended) by the board of directors of a business firm and approved by their
shareholders.
2. Preference Dividend:
• Preference dividend is paid on Preference Shares. At the time of issue of such shares, the
rate of dividend is mentioned which remains fixed in nature. This dividend on preference
shares is paid before equity dividend. The board of directors of a business firm does not
put any recommendation towards preference dividend viz. rate, payment mode etc.
3. Interim Dividend:
• Interim dividend is paid by a company for the current year before the accounts for that
period have been closed. Such dividend is paid when the company has heavy earnings
during the year.
Types of Dividend
4. Regular Dividend:
• Payment of dividend at the usual rate is termed as regular dividend. The
investors such as retired persons, widows and other economically weaker
people prefer to get regular dividends.
5. Cash Dividend:
• A cash dividend is a usual method of paying dividends. Payment of dividend
in cash results in outflow of funds and reduces the company’s net worth,
though the shareholders get an opportunity to invest the cash in any manner
they desire. This is why the ordinary shareholders prefer to receive dividends
in cash.
• But the firm must have adequate liquid resources at its disposal or provide
for such resources so that its liquidity position is not adversely affected on
account of cash dividends.
Types of Dividend
6. Stock Dividend:
• Stock dividend means the issue of bonus shares to the existing
shareholders. If a company does not have liquid resources it is better to
declare stock dividend. Stock dividend amounts to capitalization of
earnings and distribution of profits among the existing shareholders
without affecting the cash position of the firm.
7. Scrip or Bond Dividend:
• A scrip dividend promises to pay the shareholders at a future specific date.
In case a company does not have sufficient funds to pay dividends in cash,
it may issue notes or bonds for amounts due to the shareholders. The
objective of scrip dividend is to postpone the immediate payment of cash.
A scrip dividend bears interest and is accepted as a collateral security.
Types of Dividend
8. Property Dividend:
• Property dividends are paid in the form of some assets other than cash. They are
distributed under exceptional circumstances and are not popular in India.
9. Composite Dividend:
• When dividend is paid partly in cash and partly in the form of property then it is
known as composite dividend.
10. Optional Dividend:
• Instead of paying a composite dividend, if the company gives option to its shareholders
either for cash dividend or for property dividend then it is called option dividend.
11. Extra or Special Dividend:
• Special dividend is an abnormal and non-recurring form of dividend, when the
management of a company does not want to make frequent changes in the regular rate
of dividend but company is having good amount of profits or undistributed reserves
then they can declare extra or special dividend.
Approaches/ models
Gordon’s Model:
• According to Gordon’s Model, the value of the share is given by the
following equation:
2.
•
Walter’s Model:
Walter’s Dividend model measures the effect of dividend on common
stock value by making a comparison of the actual and normal
capitalization rates i.e. –
• As per Walter’s model the rate of return on investment and cost of capital
determine the price of share. If r > k, the price per share increases as
dividend payout ratio decreases. If r < k the price per share increases as
dividend payout ratio increases. The dividend pay-out ratio has no effect
on the price of the share if r = k.
• Under the circumstance, the optimal pay-out ratio (i) for a growth firm (r
> k) is nil (ii) declining firm (r < k) is 100 percent and (iii) for a normal
firm (r = k) is irrelevant.
3. Modigliani-Miller Theory:
According to MM approach, the dividend policy of a firm has no effect on the value of the firm.
This approach is based on certain assumptions which are as follows:
Assumptions:
(a) There are perfect capital markets and investors are rational.
(b) Information is freely available and there are numerous transactions.
(c) An investor cannot influence prices.
(d) Flotation costs are nil.
(e) There are no taxes.
(f) The firm has a fixed investment policy.
(g) Risk of uncertainty does not exist.
Mathematical Proof of MM Approach:
E.g., – A company has a P/E (Price/Earnings) ratio of 10. The amount of share Capital is Rs.
50,00,000 dividend into shares of Rs. 100 each. The company expects a declaration of dividend of Rs.
8 per share. On the assumption that the company pays dividend, its net income is Rs. 5,00,000 and it
makes new investments of Rs. 10,00,000 during the period proven under the MM assumption that the
value of the firm remains unchanged when.
(a) Dividends are paid; and