Dividend Decision

Introduction

The term dividend refers to that portion of profit which is distributed among the shareholders of the firm.

It is the reward of the shareholders for investments made by them in the shares of the company.

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.

Factors Influencing Dividend Policy

Legal restrictions: legal provisions require that dividend can be paid only out of current profits or past profits after providing for depreciation or out of the money provided by Government for payment of Dividend in pursuance of given by the Government.

Magnitude and trend of earning: As the dividend can be paid only out of present or past years profit, earnings of the company fix the upper limits on dividend.

Desire and type of share holder: Desire of share holder for dividend depend upon their economic status. Investors, such as retired persons, widows and other economically weaker persons view dividend as a source of fund to meet their day to day living expenses.

contd..

Nature of industry: Nature of industry to which the company is engaged also considerably affect the dividend policy.

Age of the company: A newly established concern has to limit the payment of dividend and retain substantial part of earnings for financing its future growth and development. While older companies which have established sufficient reserve can afford to pay liberal dividend.

Future financial requirement: It is not only the desires of the share holder, but also future financial requirement of the company that have to be taken into consideration while making a dividend decision.

Government’s economic policy: The dividend policy of a firm has also to be adjusted to the economic policy of the Government as was the case the temporary restrictions on payment of dividend ordinance was in force.

Taxation policy: A high or low rate of business taxation affects the net earning of company and there by its dividend policy.

Inflation: Inflation acts as a constraint in the payment of dividend.

Control objective: When a company pays high dividends out of its earnings, it may result in the dilution of both control and earning for the existing share holders.

Requirement of institutional investors: Dividend policy of a company can be affected by the requirements of institutional investors such as financial institution, bank, insurance corporation etc.,

Stability of dividend: Stability of dividend simply refers to the payment of dividend regularly and shareholders generally prefer payment of such regular dividends.

Liquid resources: If a company does not have liquid resources, it is better to declare stock dividend. i.e., issue of bonus share to the existing share holders.

Types of dividend PolicyRegular dividend policy: Payment of dividend at

the usual rate is termed as regular dividend.Stable dividend policy: The term “stability of

dividends” means consistency or lack of variability in the stream of dividend payments. a) Constant dividend per share: some companies

follow a policy of paying fixed dividend per share irrespective of the level of earnings year after year

b) Constant payout ratio: means payment of a fixed percentage of net earnings as dividends every year. The amount of dividend fluctuates in direct proportion to the earnings of the company.

Contd..c) Stable rupee dividend plus extra dividend: some

co’s follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profits.

Irregular dividend policy: some companies follow irregular dividend payments on account of the foll-ga)uncertainty of earnings.b)unsuccessful business operations c)lack of liquid resources.

No dividend policy: a company may follow a policy of paying no dividends presently because of its unfavourable working capital position.

Forms of Dividend DIVIDENDS paid in the ordinary course of business are

known as PROFIT DIVEDEND, while dividends paid out of capital are known as LIQUIDATION DIVIDENDS. Dividends may also be classified on the basis of medium in which they are paid:

Cash dividend: 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.

Scrip or bond dividend: a script 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.

Contd..Property dividend: are paid in the form of

some assets other than cash. They are distributed under exceptional circumstances & are not popular in India.

Stock dividend: means issue of bonus shares to the existing shareholders.

CORPORATE DIVIDEND PRACTICES IN INDIABecause of liberalization of Indian economy

in recent years, the share holders/investors are aware of the events of the industrial sectors of the company.

The up surge of the capital market both primary and secondary will bear testimony of such awareness. 

In India, capital market today is not a place for yield and dividend payments do not make much of a dent as far as returns are concerned.

Only companies with conservative payout companies which believe in ploughing profits back and

employing them productively will be in a position

to issue bonus shares by capitalizing reserves . In an era of high interest costs, it is conservation

of resources that is far more important than their dividend distribution .

Moreover, even though there may be liberal distribution of dividend, the real yield to the investor who has acquired the share at their market value may be very negligible.

For Example : Tata Tea , a renowned company may distribute dividend at a percentage as high as 50% .

Approaches to Dividend PolicyHowever, there are conflicting opinions regarding

the impact of dividend policy on the valuation of the firm.

According to one School of thought, dividends are irrelevant, so the dividends have no impact on the value of the firm.

According to second School of thought, dividends are relevant to the value of the firm measured in terms of market prices of the shares.

1. The Irrelevance Concept of Dividend or The Theory of Irrelevance.

A. Residual Approach According to this theory, dividend decision has

no effect on the wealth of the shareholders or the prices of the shares, and hence it is irrelevant so far as the valuation of the firm is concerned.

This theory regards dividend decision merely as a part of financing decision because the earnings available may be retained in the business for re-investment.

But, if funds are not required in the business they may be distributed as dividends.

Thus, the decision to pay dividends or retain the earnings may be taken as a residual decision.

This theory assumes that investors do not differentiate between dividends and retentions by the firm.

B. Modigliani and Miller Approach Modigliani and Miller have expressed in the most

comprehensive manner in support of the theory of irrelevance.

They maintained that dividend policy has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy.

As observed by M.M, “under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares.”

2. The Relevance Concept of Dividend or The Theory of Relevance

The other School of thought on dividend decision holds that the dividend decisions considerably affect the value of the firm.

The advocates of this school of thought include Myron Gordon, Jone Linter, James Walter and Richardson.

According to them dividends communicate information to the investors about the firm’s profitability and hence dividend decision becomes relevant.

Those firms which pay higher dividends, will have greater value as compared to those which do not pay dividends or have a lower dividend pay out ratio.

The following are the two theories representing this notion:

A. Walter’s Approach Prof. Walter’s approach supports the doctrine

that dividend decisions are relevant and affect the value of the firm.

The relationship between the internal rate of return earned by the firm and its cost of capital is very significant in determining the dividend policy to sub serve the ultimate goal of maximizing the wealth of the shareholders.

Walter’s Model is based on the following assumptions:

- The investment of the firm is financed through retained earnings only and the firm does not use external sources of funds.

- The internal rate of return and the cost of capital are constant.

- Earnings and dividends do not change while determining the value.

- The firm has a very long life.

B. Gorden’s Approach Myron Gorden has also developed a model on

the lines of Prof. Walter suggesting that dividends are relevant and the dividend decision of the firm affects its value.

His basic valuation model is based on the following assumptions:

- The firm is an all equity firm.- No external financing is available or used.- The rate of return on the firm’s investment is

constant.- The retention ratio once decided upon is constant.

- The cost of capital for the firm is constant.- The firm has perpetual life.- Corporate taxes do not exist.