Introduction

Net earning has two parts- Retained earning and Dividends

Retained earning used for further investment

Dividends are paid in cash to shareholders

Dividend increases the value of share

Practical Consideration in Paying Dividends

Depend upon firms financial needs, growth plans and investment opportunity

Signaling information about prospects of the company

Investor preference for dividend than capital receipts for his own investments

Control over the company may be lost Resolution of investors uncertainty Ability to raise additional financeClosely / Widely Held Company

Firm’s need for fund

Growing firm generally keep major proportion of net earning. Growth firms have large number of investment opportunity

hence they should give precedence to retention of earning. Matured firms have infrequent investment opportunity hence

they should distribute most of their earning. It is argued that when IRR (return on investment) is greater

than cost of capital, it is profitable to reinvest the net earning or most of it.

Retained earnings are preferred than external equity as they does not involve floatation costs.

Some companies prefer to raise external equity for financing investment decision.

Investor preference for dividend than capital receipts

Some shareholder’s may prefer near dividends than future dividend or capital gain.

Depends upon economic status, the effect of tax differential on dividends and capital gains.

In closely held companies, director knows shareholder’s expectations well and frame dividend policy accordingly.

Institutional investors avoid speculation

Control over the firm

If dividends are paid, cash may affectedFor further expansion company may

have to issue new shareThe control of existing shareholders will

be diluted if they do not want or cannot buy new shares

Hence payment of dividend may withheld and earning may be retained

Investor preference for dividend than capital receipts

Widely held companies : Small investors, Retired or old person and Wealthy investors.

Shareholder’s income may go against company’s investment and long term growth

Management should properly trade off between dividend and retained earning

Resolution of investors uncertainty

Dividends have informational value.It resolves uncertainty in the mind of

investor.Companies generally have to pay small

amount of income even when earnings fall.It conveys that future of the company is

bright.

Other Practical Consideration in Paying Dividends

Risk taking capability of firmFirm’s constraints- financial and legal.Policy of the company: whether stable

dividend per share or payout ratioLiquidity requirementTaxation treatment

Other Practical Consideration in Paying Dividends

Temporary excess cash on account of windfall gains and not the better investment option available to firm

Capital Budgeting decision-- If policy is independent (No impact)- If Dependent (Higher payout means

lower capital budgeting)

Stability of dividends

It has the positive effect on market price of the share.

It also mean regularity in paying some dividend annually.

Three forms of dividend stability Constant dividend per share (dividend rate) Constant payout Constant dividend per share plus extra dividend.

Constant dividend per share

In India, companies announces dividend as a percent of the paid-up capital per share.

Dividend rate may increase.

EPS

DPS

Time

EPS&DPS

Constant Dividend per Share plus Extra Dividend

Generally adopted by companies with fluctuating earnings.

Policy to pay a minimum dividend per share with a step up feature.

Paying extra in period of prosperity. Known as interim dividend with final dividend. It helps in paying dividend without a default.

Merits of stability of dividends

It has several advantages.Resolution of investors uncertainty.Investors’ desire for current income.Institutional investors requirements.Raising additional finances.

Danger of stability of dividends

Once established, difficult to change.It creates a clientele that depends on it.Have to maintain the stability even

during lean years.Hence dividend rate should be fixed at

conservative figures.

Constant Payout

The rate of dividend to earning is known as payout ratio.

Some company may follow a policy of constant payout ratio.

Paying a fixed percentage of earning per year. Amount of dividend fluctuates in direct proportion

to earning. In losses, no dividend shall be paid.

Constant Payout

EPS

DPS

Time

EPSandDPS

Constraints on paying dividends A high leveraged firm expected to retain more to

strengthen its position. Raising much external equity will adversely

affect the firm’s financial flexibility. Financial flexibility includes the firm’s ability to

access external funds at later date. Access to capital market. Restriction in loan agreements. Lenders may put restrictions on dividend

payment until some conditions met.

Issues in dividend policy

Low policy payout may produce higher share price but not always

Dividend is a current earning while capital gain is a future earning

Dividend yield = dividend per share/ market price per share

Dividend are generally taxed more than capital gain

Legal and procedural aspects to be considered in dividend policy

Companies can only pay cash dividend (with the exception of bonus shares)

Dividend can not be declared for past years

Dividend can be declared out of the profit of the same financial year and after providing for the government dues and depreciation under companies act

Conclusion

Don’t pay dividend on the expense of new project can give better returns than cost of equity

Try to avoid the new equity raising Frame dividend policy based on - Targeted debt-equity ratio- Investment needs of the company- Capital market norms and tax code- Avoid dividend cuts

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