Dividend policy

dividend policy and its methods

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.

11. Dividend Types

12. Types of 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.

15. Dividend theories

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 The firm is an all-equity firm; only the retained earnings are used to finance the investments, no external source of financing is used. The rate of return (r) and cost of capital (K) are constant. The life of a firm is indefinite. Retention ratio once decided remains constant. Growth rate is constant (g = br ) Cost of Capital is greater than br

28. Criticism of Gordon’s Model 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. 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. 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 .