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Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

Issues in Dividend Policy for Financial Management and Policy MCOM Sem 2 Delhi University :  The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximize their wealth. A company, on the other hand, needs to provide funds to finance its long-term growth.

If a company pays out as dividend most of what it earns, then for business requirements and further expansion it will have to depend upon outside resources such as issue of debt or new shares. Dividend policy of a firm, thus affects both the long-term financing and the wealth of shareholders.

Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

Dividend Decision and Value of Firms:

The value of the firm can be maximized if the shareholders’ wealth is maximized. There are conflicting views regarding the impact of dividend decision on the valuation of the firm. According to one school of thought, dividend decision does not affect the share-holders’ wealth and hence the valuation of the firm. On the other hand, according to the other school of thought, dividend decision materially affects the shareholders’ wealth and also the valuation of the firm.

We will discuss below the views of the two schools of thought under two groups:

1. The Irrelevance Concept of Dividend or the Theory of Irrelevance, and

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

Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

Determinants of Dividend Policy

The payment of dividend involves some legal as well as financial considerations.

The following are the important factors which determine the dividend policy of a firm:

1. Legal Restrictions: Legal provisions relating to dividends in the Companies Act, 1956 lay down a framework within which dividend policy is formulated. These provisions require that:

• Dividend can be paid only out of current profits or past profits after providing for depreciation or out of the moneys provided by Government for the payment of dividends in pursuance of a guarantee given by the Government.

• A company providing more than ten per cent dividend is required to transfer certain percentage of the current year’s profits to reserves.

• The dividends cannot be paid out of capital, because it will amount to reduction of capital adversely affecting the security of its creditors.

2. Magnitude and Trend of Earnings: As dividends can be paid only out of present or past year’s profits, earnings of a company fix the upper limits on dividends. The dividends should, generally, be paid out of current year’s earnings only as the retained earnings of the previous years become more or less a part of permanent investment in the business to earn current profits. The past trend of the company’s earnings should also be kept in consideration while making the dividend decision.

3. Desire and Type of Shareholders: Desires of shareholders for dividends depend upon their economic status. Investors, such as retired persons, widows and other economically weaker persons view dividends as a source of funds to meet their day-to-day living expenses. To benefit such investors, the companies should pay regular dividends. On the other hand, a wealthy investor in a high income tax bracket may not benefit by high current dividend incomes. Such an investor may be interested in lower current dividends and high capital gains.

4. Nature of Industry: Certain industries have a comparatively steady and stable demand irrespective of the prevailing economic conditions. For instance, people used to drink liquor both in boom as well as in recession. Such firms expect regular earnings and hence can follow a consistent dividend policy. On the other hand. If the earnings are uncertain, as in the case of luxury goods, conservative policy should be followed.

5. Age of the Company: The age of the company also influences the dividend decision of a company. A newly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth and development, while older companies which have established sufficient reserves can afford to pay liberal dividends.

6. Future Financial Requirements: The management of a concern has to reconcile the conflicting interests of shareholders and those of the company’s financial needs. If a company has highly profitable investment opportunities it can convince the shareholders of the need for limitation of dividend to increase the future earnings.

7. Economic Policy: The dividend policy of a firm has also to be adjusted to the economic policy of the Government as was the case when the Temporary Restriction on Payment of Dividend Ordinance was in force. In 1974 and 1975, companies were allowed to pay dividends not more than 33 per cent of their profits or 12 per cent on the paid-up value of the shares, whichever was lower.

8. Taxation Policy: The taxation policy of the Government also affects the dividend decision of a firm. A high or low rate of business taxation affects the net earnings of company (after tax) and thereby its dividend policy. Similarly, a firm’s dividend policy may be dictated by the income-tax status of its shareholders. If the dividend income of shareholders is heavily taxed being in high income bracket, the shareholders may forego cash dividend and prefer bonus shares and capital gains.

9. Inflation: Inflation acts as a constraint in the payment of dividends. when prices .rise, funds generated by depreciation would not be adequate to replace fixed assets, and hence to maintain the same assets and capital intact, substantial part of the current earnings would be retained. Otherwise, imaginary and inflated book profits in the days of rising prices would amount to payment of dividends much more than warranted by the real profits, out of the equity capital resulting in erosion of capital.

10. Control Objectives: As in case of a high dividend pay-out ratio, the retained earnings are insignificant and the company will have to issue new shares to raise funds to finance its future requirements. The control of the existing shareholders will be diluted if they cannot buy the additional shares issued by the company.

11. Requirements of Institutional Investors: Dividend policy of a company can be affected by the requirements of institutional investors such as financial institutions, banks insurance corporations, etc. These investors usually favor a policy of regular payment of cash dividends and stipulate their own terms with regard to payment of dividend on equity shares. 

12. Stability of Dividends: Stability of dividend simply refers to the payment of dividend regularly and shareholders, generally, prefer payment of such regular dividends. Some companies follow a policy of constant dividend per share while others follow a policy of constant payout ratio and while there are some other who follows a policy of constant low dividend per share plus an extra dividend in the years of high profits.

13. Liquid Resources: The dividend policy of a firm is also influenced by the availability of liquid resources. Although, a firm may have sufficient available profits to declare dividends, yet it may not be desirable to pay dividends if it does not have sufficient liquid resources. If a company does not have liquid resources, it is better to declare stockdividend i.e. issue of bonus shares to the existing shareholders. The issue of bonus shares also amounts to distribution of firm’s earnings among the existing shareholders without affecting its cash position. 

Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

Bonus Issue

A company can pay bonus to its shareholders either in cash or in the form of shares. Many a times, a company is not in a position to pay bonus in cash in spite of sufficient profits because of unsatisfactory cash position or because of its adverse effects on the working capital of the company. In such cases, if the articles of association of the company provide, it can pay bonus to its shareholder in the form of shares by making partly paid shares as fully paid or by the issue of fully paid bonus shares. Issue of bonus shares in lieu of dividend is not allowed as according to Section 205 of the Companies Act, 1956, no dividend can be paid except in cash.

It cannot be termed as a gift because it only represents the past sacrifice of the shareholders. When a company accumulates huge profits and reserves, its balance sheet does not reveal a true picture about the capital structure of the company and the shareholders do not get fair return on their capital. Thus, if the Articles of Association of the company so permit, the excess amount can be distributed among the existing shareholders of the company by way of issue of bonus shares.

The effect of bonus issue is two-fold:

(i) It amounts to reduction in the amount of accumulated profits and reserves.

(ii) There is a corresponding increase in the paid up share capital of the company. 

Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

Reasons for issue of Bonus Shares

Companies have a common tendency to issue bonus shares to their shareholders. Many companies have issued bonus shares once a while, whereas some other companies have issued bonus shares on regular basis. Companies such as Bajaj Auto Ltd., Hindustan Level Ltd. have issued bonus shares on regular basis. Companies prefer issue of bonus shares as against payment of cash dividend for several reasons as follows:

1.            When a company issues bonus shares, it utilises a part of profit of company and also rewards the shareholders but without affecting liquidity of company.

2.            Since, bonus shares is capital receipt, it is not taxable in hands of issuing company as well as shareholders.

3.            Issue of bonus shares increases the goodwill of company in capital market and build confidence among investors and helps raising additional funds in future.

4.            Bonus issue helps a company to streamline its capital structure and bring its paid-up capital in line with capital employed in business.

5.            It makes available capital to carry on a larger and more profitable business.

6.            It enables a company to make use of its profits on a permanent basis and increases creditworthiness of the company.

7.            The balance sheet of the company will reveal a more realistic picture of the capital structure and capacity of the company.

8.            The investors can easily sell these shares and get immediate cash, if they so desire.

9.            The bonus shares are a permanent source of income to the investors.

Issues in Dividend Policy for Financial Management and Policy Mcom Sem 2 Delhi University

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