This ppt is prepared to make familiar with the dividend policy which includes Types of Dividend policy, Procedure for declaring dividend, Why do companies declare dividend

1. Sundar B. N. Assistant Professor
Why do companies pay dividends?
If investors have to pay higher taxes on dividends than in capital gains,
then firms that pay dividends should have a higher cost of equity than
firms that do not pay dividends.
Thus, why do firms pay dividends?
One argument to justify the payment of dividends is that dividends are
cash in hand, while capital gains are cash in the bush. Capital gains to be
received in the future should be riskier than the dividends received
today.
Think about investor YES who invested in a firm that pays dividends
and investor NO who holds shares of a firm that does not pay dividends.
Is investor YES better off than investor NO? Investor YES receives the
cash now, but what is she going to do with this cash? She might want to
spend it, but investor NO could also sell her shares and spend the
proceeds. If investor YES wants to invest the money she will face the
appropriate level of risk.
It is important to remember that the value of the firm is equal to future
cash flows discounted at the appropriate discount rate. There is no
reason to think that the future cash flows will change with the dividend
policy, and under the M&M assumptions, there is no reason to believe
that the payment of dividends will change the discount rate.
MEANING OF DIVIDEND POLICY
Dividends refer to that portion of a firm's net earnings which are paid to
shareholders. Dividend is paid either in cash or stock. Since dividends
are distributed out of the profits, the alternative to the payment of
dividends is the retention of earnings. The retained earnings constitute an
important source of financing the investment requirements of the firm.
There is inverse relationship between retained earnings and cash
dividends. More dividends result in smaller retentions where as lesser
dividend results in larger retentions. Thus, dividends and retained
earnings are competitive and conflicting.
Dividend decision refers to the decisions regarding the division of net
earnings to the dividend and retained earnings. A firm can distribute all
of its earnings to the shareholders as dividends or can retain all of its
earnings for reinvestment as retained earnings or can distribute a part of
earnings as dividend and retain the balance for re-investment purpose.
Dividend decision is a major financial decision in the sense that a firm
has to choose between distributing profits to the shareholders and
ploughing back them into the business. The selection would be
influenced by the effect on the objective of financial management of
maximizing shareholder's wealth.
Given the objective of financial management of maximizing
shareholder's wealth, the firm should be guided by the consideration as
which alternative use of net earnings is consistent with the goal of
wealth maximization. If paying dividends to shareholders will maximize
the wealth of shareholder, the firm would be advised to use earnings for
paying dividends to shareholders. The firm would be advised to retain
the earnings if retaining earning will end to the maximization of wealth.
Thus, optimal dividend policy is one which leads to maximization of
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2. Sundar B. N. Assistant Professor
On the other hand, certain theories consider the dividend decision as relevant to the value of the
firm. The dividend decision has effect on the value of the firm. This view is led by J.E. Walter,
M.J. Gordon and others.
The arguments given are support of irrelevance theory of dividend seems not to be hold true.
Therefore, it should be concluded that dividend policy is relevant. A firm should try to follow an
optimum dividend policy which maximizes the shareholder's wealth in long run. An optimum
dividend policy will vary from firm to firm as it is determined by a number of factors.
DIVIDEND PAYOUT RATIO AND RETENTION RATIO
Dividend policy decision refers to the decision to pay out earnings or to retain them for
reinvestment in the firm Dividend refers to the portion of net income paid out to the shareholders.
The percentage of earnings paid out in form of cash dividend is known as dividend payout ratio.
Dividend payout ratio can be calculated as under.
Dividend Paid
Divide Payout ratio = Net income Or
Dividend Per Share
Earning Per Share
Dividend Paid
No. of common shares outs tan ding
Net income
= No. of common shares outs tan ding
Where,
Dividend Per Share =
Earnings Per Share
A firm may retain same portion of its earnings for reinvestment purpose. The percentage of
earnings retained in the firm is called retention ratio. High dividend payout ratio means low
retention ratio and vice versa.
Retention ratio is calculated as under :
Retention ratio= 1 - Dividend Paid out ratio
Or
Re tained earnings Net income
DIVIDEND PAYMENT PROCEDURES
Cash dividend refers to the portion of net income paid out to shareholders in cash. The dividend
payment procedures of a company can be described as under:
1. Declaration date
The date at which board of directors meet and issue a statement declaring dividend is called
declaration date. The board of directors set the amount of dividend to be paid, the holder - of -
record date and the payment date on this date. Generally, dividend is announced as a percentage
of the per value of stock. However, it can be the absolute amount like Rs 5 per share in some
cases.
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3. Sundar B. N. Assistant Professor
2. Holder - of - record date
The date on which the company opens the ownership books to make a list of shareholders who are
entitled to receive the dividend is called holder - of - record date. All the stockholders of the record
date are entitled to receive the dividend declared by the board of directors. The new stockholders
would receive dividend if the name of shareholders is recorded in the ownership book on or before the
date of record. However, if the notification about the transfer was received after the date of record, the
old owner of the stock would receive the dividends.
3. Ex - dividend date
Ex-dividend date is two business days prior to the record date. Shares purchased after the ex-dividend
date are not entitled to the dividend. The transaction must take place before the ex-dividend date to
entitle the new holder to receive dividend. Thus, the date when the right to the dividend leaves the
stock for new owner is called exdividend date.
4. Payment date
The date on which the company actually pays dividends or mails the cheques to the stockholders is
called payment date. On this date, the company actually pays the dividend to all the stockholders of the
date of record.
FACTORS AFFECTING DIVIDEND POLICY
Dividend policy is concerned with determining the proportion of firm's net income to be distributed in
the form of dividend and the proportion of earnings to be retained for investment purpose. A firm's
dividend policy is influenced by a number of factors. Some of the major factors influencing the firm's
dividend policy are as under :
(1) Legal rules
There are certain legal rules that may limit the amount of dividends a firm may pay. Following are the
rules relating to dividend payment:
(a) Net profit rule : According to this rule, dividends can be paid out of present or past earnings.
Amount of dividends cannot exceed the accumulated profits. If there is accumulated loss, it must be set
off out of the current earnings before paying out any dividends.
(b) Insolvency rule :- According to this rule, a firm cannot pay the dividends when its liabilities
exceed assets. When the firm's liabilities exceed its assets, the firm is considered to be financially
insolvent. The firm, financially insolvent, is prohibited by law to pay dividends.
(c) Capital impairment rule :- According to this rule, a firm can not pay dividend out of its paid up
capital. The dividend payout that impairs capital is considered illegal.
2. Desire of shareholders
Dividend policy is affected by the desire of shareholders Shareholders may be interested either in
dividend income or capital gain. Wealthy shareholders may be interested in capital gain as against
dividend income because of low tax rate on
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capital gain. Whereas the shareholders, whose sources of income is dividend only, are interested in
dividend income and would not be interested in capital gain.
3. Liquidity position
In order to pay dividend, a company requires cash, and, therefore, the availability of cash resources within
the company will be a factor in determining dividend payments. Generally, the greater the cash position
and overall liquidity of a company, the greater is the ability to pay dividends. A company must have
adequate cash available as well as retained earnings to pay dividends. The liquidity position of the
company will influence the dividend payout of a particular year.
4. Rate of expansion of business
The rate of asset expansion needs to be taken into account. The more rapid the rate at which the firm is
growing, the greater will be its needs for financing assets expansion. The greater the future need for
funds, the more likely the firm is to retain earnings rather than pay them out.
5. Cost of external financing
The cost of external financing will have impact on the dividend payout of a company. In situations, where
the external funds are costlier, a firm may resort to low dividend payout and use the internal funds for
financing its business.
6. Need to repay debt
They need to repay debt also influence the availability of cash flow to pay dividend. If a firm has to repay
debt in a particular year, firm may decide to low dividend payout and use the funds to repay the debt.
7. Contractual constraints
When the company obtained loan funds from debenture holders or term lending institutions, the terms of
issue or contract of loan may contain restrictions on dividend payments. Debt contracts often stipulate
that no dividends can be paid unless the current ratio, times interest earned ratio and other safety ratios
exceed stated minimums.
8. Access to the capital market
The company, which has a good access to capital market, can follow a liberal dividend policy because
this type of the company can raise the required funds from the capital market.
9. Degree of control
One of the important influencing factors on dividend policy is the objective of maintaining control over
the company by the existing management or shareholders. The management who wish to maintain close
control over the company will not much depend on the external sources of finance, and they maintain a
low dividend payout policy and the funds generated from operations would be used for working capital
and capital investment needs of the firm.
10. Tax position of shareholders
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5. Sundar B. N. Assistant Professor
The tax position of shareholders also influences dividend policy. The company owned by wealthy
shareholders having high income tax bracket tend toward lower dividend payout where as the
company owned by small investors tend toward higher dividend payout.
11. Stability of earnings
The stability of earnings also effects the dividend policy decision. If the earnings of a firm are
relatively stable, the firm is more likely to payout a higher percentage of earnings than the firm
which has fluctuating earnings.
12. General state of economy
When state of economy is uncertain, both political and economic, the firm may maintain a low
dividend payout policy, to withstand to the business risks.
TYPES OF DIVIDENDS:
Classifications of dividends are based on the form in which they are paid.
Following given below are the different types of dividends:
□ Cash dividend □ Bonus Shares referred to as stock dividend in USA □ Property dividend interim
dividend, annual dividend. □ Special- dividend, extra dividend etc. □ Regular Cash dividend □ Scrip
dividend □ Liquidating dividend □ Property dividend
CASH DIVIDEND:
Companies mostly pay dividends in cash. A Company should have enough cash in its bank account
when cash dividends are declared. If it does not have enough bank balance, arrangement should be
made to borrow funds. When the Company follows a stable dividend policy, it should prepare a cash
budget for the coming period to indicate the necessary funds, which would be needed to meet the
regular dividend payments of the company. It is relatively difficult to make cash planning in
anticipation of dividend needs when an unstable policy is followed. The cash account and the
reserve account of a company will be reduced when the cash dividend is paid. Thus, both the total
assets and net worth of the company are reduced when the cash dividend is distributed. The market
price of the share drops in most cases by the amount of the cash dividend distributed.
STOCK DIVIDEND/BONUS SHARES
Stock dividend refers to the dividends paid to the existing stockholders in the form of additional
shares of common stock. It represents a distribution of additional shares to existing shareholder.
Stock dividend increases the number of outstanding shares of the firm's stock. It involves simply an
accounting entry transfer from retained earnings account to the common stock and paid in capital
accounts. Due to stock dividend, retained earnings decrease, common stock and paid in capital
increase. The stock dividend does not affect the equity position of stockholders. Market price per
share and earning per share after stock dividend will decrease.
No. of bonus shares = No. of shares outstanding x % of stock dividend.
Decrease in Retained earnings = No. of bonus shares x Market price per share.
Increase in common stock = No. of bonus shares x par value per share.
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Increase in paid in capital = No. of bonus shares x paid in capital per share.
Marker price per share after stock dividend =
Market price per share before stock dividend
. , 1 + stock dividend in fracton
Advantages
The important benefits derived from stock dividend or issue of bonus shares are as follows :
1. It preserves the company's liquidity as no cash leaves the company.
2. The shareholders receive a dividend which can be converted into cash whenever he wishes
through selling the additional shares.
3. It broadens the capital base and improves image of the company.
4. It reduces the marker price of the shares, rendering the shares more marketable.
5. It is an indication to the prospective investors about the financial soundness of the company.
6. The shareholders can take the advantage of tax saving from stock dividend. Disadvantages
1. The future rate of dividend will decline.
2. The future market price of share falls sharply after bonus issue.
3. Issue of bonus shares involve lengthy legal procedures and approvals.
STOCK SPLIT
A stock split is a method to reduce the marker price per share by giving certain number of share
for one old share. Due to stock split, number of outstanding shares increase and par value and
marker price of the stock decrease. A stock split affects only the par value, market value and the
number of outstanding shares. However, net worth of the company remains unaltered.
With a stock split, shareholder's equity account does not change, but the par value per share
changes. The earnings per share will be diluted and marker price per share fall propotionately with
a stock split. But, the total value of the holdings of a shareholder remains unaffected by a stock
split. Following ate the reasons for splitting a firm's ordinary shares :
1. Stock split results in reduction in market price of the share. It helps in increasing the
marketability and liquidity of a company's shares.
2. Stock splits are used by the company management to communicate to investors that the
company is expected to earn higher profits in future.
3. Stock split is used to give higher dividends to shareholders.
REVERSE STOCK SPLIT
Reverse stock split is method used to raise marker price of a firm's stock by exchanging certain
number of outstanding shares for one new share of stock. Due to reverse stock split, number of
outstanding shares decreases, par value of the shares increases and marker price per share also
increases. However, total net worth of the company remains unchanged. Reverse stock split is
used to stop the marker price per share below a certain level. The reverse split is generally an
indication of financial difficulty and is, therefore, intended to increase the marker price per share.
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REPURCHASE OF STOCK
Stock repurchase is method in which a firm buys back shares of its own stock, there by decreasing
shares outstanding, increasing earning per share, and, often increasing the stock price. It is an
alternative to cash dividends. In a stock repurchase, the company pays cash to repurchase shares
from its shareholders. These shares are usually kept in the company's treasury and then resold
when the company needs money.
If a firm has excess cash, it may purchase its own stock leaving fewer shares outstanding,
increasing the earning per share and increasing the stock price. It may be an alternative to paying
cash dividends. The benefits to the shareholders are the same under cash dividend and stock
repurchase. In the absence of personal income taxes and transaction costs, both cash dividend and
stock repurchase have no any difference to shareholders. Capital gain arising from repurchase
should equal the dividend otherwise would have been paid.
Repurchase price or equilibrium price is the price that brings capital gain equal to the cash
dividend. Share price for repurchase or the equilibrium price is calculated from the following
equation:
Repurchase Price (P*)
Where,
S x Pc S
— n
S = Total number of shares outstanding Pc = Current market price per share n =
Number of shares to be repurchased.
Share can be repurchased in different ways. A company can repurchase its shares
through authorized brokers on the open market. Shares can be also repurchased by
making a tender offer which will specify the purchases price, the total amount and
the period within which shares will be bought back. Similarly, a company can
purchase a block of shares from one large holder on a negotiated basis.
Advantages of repurchase of stock
1. A firm an use idle cash to repurchase stock if it has less investment opportunities.
2. Dividend and earnings per share will be increased through stock repurchase.
3. Stock repurchase will result in increase in the share value.
4. The buying shareholders will benefit since the company generally offer a price higher
than the current market price of the share.
5. When shares are undervalued in the market, a company can buy back shares at higher
price to move up the current share price.
6. If a company has high proportion of equity in its capital structure, if can reduce equity
capital by buying back its shares to achieve target capital structure.
7. The promoters of the company benefit by consolidating their ownership and control
over companies through stock repurchase. They do not sell their shares to the
company rather make the share repurchase attractive for others.
8. Repurchase of stock can remove a large block of stock that is overhanging the market
and keeping the price per share down.
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8. Sundar B. N. Assistant Professor
9. In a hostile takeover, a company may buy back its shares to reduce the availability of
shares and make take over difficult.
10. Stockholder are given a choice of whether or not to sell their stock to the firm.
Disadvantages of stock repurchase
1. Shareholders may not be indifferent between dividends and capital gains, and the
price of stock might benefit more from cash dividends than from repurchase.
2. The remaining shareholder may lose if the company pays excessive price for the
shares under the stock repurchase scheme.
3. Stock repurchase may signal to investors that the company does not have long - term
growth opportunities to utilize the cash.
4. The buyback of shares may be useful as a defense against hostile takeover only in
case of cash rich companies.
Special dividend : In special circumstances Company declares Special dividends.
Generally company declares special dividend in case of abnormal profits.
Extra- dividend: An extra dividend is an additional non-recurring dividend paid over and
above the regular dividends by the company. Companies with fluctuating earnings
payout additional dividends when their earnings warrant it, rather than fighting to
keep a higher quantity of regular dividends.
Annual dividend: When annually company declares and pay dividend is defined as annual
dividend.
Interim dividend: During the year any time company declares a dividend, it is defined as
Interim dividend.
Regular cash dividends: Regular cash dividends are those the company exacts to maintain
every year. They may be paid quarterly, monthly, semiannually or annually.
Scrip dividends: These are promises to make the payment of dividend at a future date:
Instead of paying the dividend now, the firm elects to pay it at some later date. The
‘scrip’ issued to stockholders is merely a special form of promissory note or notes
payable.
Liquidating dividends: These dividends are those which reduce paid-in capital: It is a pro-
rata distribution of cash or property to stockholders as part of the dissolution of a
business
Property dividends: These dividends are payable in assets of the corporation other than
cash. For example, a firm may distribute samples of its own product or shares in
another company it owns to its stockholders.
DIVIDEND POLICY THEORIES
The dividend policy theories focus on the issue of the relevancy of dividend policy to the
value of a firm.
Dividend Irrelevance
• Dividends do not make any difference (M & M theory)
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9. Sundar B. N. Assistant Professor
• If there are no taxes disadvantages associated with dividends.
Dividend Relevance
• Dividends are relevant and have positive impact on firm value
• If stockholders like dividends, or dividends operate as a signal of future prospects.
(Lintner & Gordon)
• Dividends help to resolve agency problem and thus enhancing shareholder value.
(Jenson)
• Dividends are not good (Graham and Dodd)
• If dividends have a tax disadvantage and increasing dividends reduce value.
There are therefore, conflicting viewpoints regarding the impact of dividend decision on
value of a firm.
DIVIDEND MODELS
The various models that support the above-mentioned theories of
dividend relevance and irrelevance are as follows:
Modigliani Miller approach
According to them the price of a share of a firm is determined by its
earning potentiality and investment policy and not by the pattern of
income distribution. The model given by them is as follows:
Po = D1 + P1/ (1/Ke)
Where, Po = Prevailing market price of a share Ke = Cost of equity
capital D1 = Dividend to be received at the end of period one P1 =
Market price of a share at the end of period one.
According to the MM hypothesis, market value of a share before dividend
is declared is equal to the present value of dividends paid plus the market
value of the share after dividend is declared.
The assumptions of M.M. Hypothesis are:
1. (i) Perfect capital markets;
(ii) Investors are rational;
(iii) There are no transaction costs;
(iv) Securities are infinitely divisible;
(v) No investor is large enough to influence market price of securities;
(vi) There are no floatation costs.
2. There are no taxes. Alternatively, there are no differences in tax rates
between capital gains and dividends.
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10. Sundar B. N. Assistant Professor
3. A firm has a fixed investment policy which will not change over a period of time. Financing of new
investments will not change in the required rate of return.
Walter’s approach
According to Prof. James E. Walter, in the long run, share prices reflect the present value of future+ dividends.
According to him investment policy and dividend policy are inter related and the choice of an appropriate
dividend policy affects the value of an enterprise. His formula for determination of expected market price of a
share is as follows
P = D + r/k(E-D) K
Where, P = Market price of equity share D = Dividend per share E = Earnings per share (E-D) = Retained
earnings per share r = Internal rate of return on investment k = cost of capital
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;
3. 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.
Gordon’s approach
The value of a share, like any other financial asset, is the present value of the future cash flows associated with
ownership. On this view, the value of the share is calculated as the present value of an infinite stream of
dividends. Myron Gordon's Dividend Growth Model explains how dividend policy of a firm is a basis of
establishing share value. Gordon's model uses the dividend capitalization approach for stock valuation. The
formula used is as follows:
Po = E1 (1-b) K-br
Where, Po = price per share at the end of year 0 E1 = earnings per share at the end of year 1 (1-b) = fraction of
earnings the firm distributes by way of dividends b = fraction of earnings the firm ploughs back k = rate of
return required by shareholders r = rate of return earned on investments made by the firm br = growth rate of
dividend and earnings The models, provided by Walter and Gordon lead to the following implications: If r > k
Price per share increases as dividend payout ratio decreases If r = k Price per share remains unchanged with
changes in dividend payout ratio If r < k Price per share increases as dividend payout ratio increases.
Gordon’s model is based on the following assumptions.
One very popular model explicitly relating the market value of the firm to dividend policy is developed by
Myron Gordon.
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11. Sundar B. N. Assistant Professor
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant forever.
8.K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
SUMMARY
Dividend Policy is concerned with the decisions regarding division of net income to the dividend and retained
earnings. The firm should determine optimum dividend policy which leads the firm to stockholders wealth
maximization. A company can adopt either residual dividend policy or stable dividend policy. Three alternative
stable dividend policies are constant dividend per share, constant dividend pay out and regular plus extra dividend
policy.
A firm's dividend payment procedures start with determining the declaration date on which board of directors
declare dividends to be paid, the holders of record date and payment date.
A firm's dividend policy is influenced by a large no. of factors like legal requirements, desire of shareholders,
liquidity position; need to repay debt, desire of control, rate of business expansion, access to capital market, tax
position of shareholders, restrictions in debt contracts etc.
Cash dividend is the dividend, which is distributed to shareholders in cash. Due to cash dividend, total assets as
well as net worth decrease as cash and retained earnings decrease. The market price of share also decreases by the
amount of cash dividend distributed.
A stock dividend refers to the dividend distributed to existing shareholders in the form of additional shares rather
than in cash. Due to stock dividend, no. of outstanding shares increases, Common stock and paid in capital
increases and retained earnings decrease. However, net worth remains unchanged.
Stock split increases the number of outstanding shares with a proportionate decrease in par value. Reverse stock
split decreases the number of shares outstanding with a proportionate increase in par value. With a stock split and
reverse stock split, shareholder's equity remains unchanged.
In a stock repurchase, a firm buys back some of its outstanding shares, thereby decreasing number of shares,
increasing earnings per share and marker price. It is an alternative to paying cash dividend.
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