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Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

Types of Dividend Polices in Practice for Financial Management and Policy MCOM Sem 2 Delhi University : The payment of dividend involves some legal as well as financial considerations. It is difficult to determine a general dividend policy which can be followed by different firms at different times because dividend decision has to be taken considering the special circumstances of an individual case. The following are important factors which determine dividend policy of a firm:

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

1. Legal Restrictions: Legal Provisions relating to dividends as laid down in section, 205, 205A, 206 and 207 of companies Act, 1956 are significant because they lay down a framework within which dividend policy is formulated. These provisions require that dividend can be paid only out of current profit or past profits after providing for depreciation. The companies (Transfer of Profits to Reserves) Rules, 1975 require a company providing more than 10% dividend to transfer certain percentage of current year’s profit to Reserves.

Companies Act, further provides that dividend cannot be paid out of capital, because it will amount to reduction of capital adversely affecting the security of creditors.

2. Desire and Type of Shareholders: Although, legally, the direction as to whether to declare dividend or not has been left with BOD, the directors should give importance to desires of shareholders in declaration of dividends as they are representatives of shareholders. Investors such as retired persons, widows, and other economically weaker persons view dividends as source of funds to meet their day-to-day living expenses. To benefit such investors, the companies should pay regular dividends. On 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 dividend and high capital gains.

3. Nature of Industry: Nature of Industry to which company is engaged also considerably affects dividend policy. Certain industries have comparatively steady and stable demand irrespective of prevailing economic conditions. For example, people used to drink liquor both in boom as well as in recession. Such firms expect regular earnings and hence follow consistent dividend policy. On the other hand, if earnings are uncertain, as in the case of luxury goods conservative policy should be followed. Such firms should retain  a substantial part of their current earnings during boom period in order to provide funds to pay adequate dividends in the recession periods. Thus, industries with steady demand of their products can follow a higher dividend payout ratio while cyclical industries should follow a lower payout ratio.

4. Age of Company: It also influences dividend decision of company. A nearly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth while older companies which have established sufficient reserves can afford to pay liberal dividends.

5. Future Financial Requirements: If a company has highly profitable investment opportunities it can convince the shareholders of need for limitation of dividend to increase future earnings and stabilise its financial position. But when profitable investment appointments do not exist then company may not be justified in retaining substantial part of its current earnings. Thus, a concern having few internal investment opportunities should follow high payout ratio as compared to one having more profitable investment opportunities.

6. Liquid Resources: The dividend policy of a firm is also influenced by availability of liquid resources. Although, a firm may have sufficient available profit to declare dividends, yet it may not be desirable to pay dividend if it does not have sufficient liquid resources. Hence liquidity position of company is an important consideration in paying dividends. If company does not have liquid resources, it is better to declare stock dividend i.e. issue of bonus shares to existing shareholders.

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

8. Stability of Dividends: Stability of dividend refers to 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 follow a policy of constant low dividend per share plus an extra dividend in years of high profits. A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over a number of years or those who have built up sufficient reserves to pay dividends in years of low profits. The policy of constant payout ratio i.e. paying a fixed percentage of net earnings every year may be supported by firm because it is related to firms ability to pay dividends. The policy of constant low dividend per share plus some extra dividend in years of high profits is suitable to firms having fluctuating earnings from year to year.

9. Magnitude and Trend of Earnings: The amount and trend of earnings is an important aspect of dividend policy. It is rather the starting point of the dividend policy. As dividends can be paid only out of present or past’s years profits, earnings of a company fix the upper limits on dividends. The dividends should nearly be paid out of current years earnings only as 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 dividend decision.

10. Control objectives: When a company pays high dividends out of its earnings, it may result in dilution of both control and earnings for existing shareholders. As in case of high dividend pay out ratio the retained earnings are insignificant and 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 additional shares issued by the company. Similarly issue of new shares shall cause increase in number of equity shares and ultimately cause a lower earnings per share and their price in the market. Thus under these circumstances to maintain control of the existing shareholders, it may be desirable to declare lower dividends and retain earnings to finance the firm’s future requirements.

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

Types of Dividend Policy

The various types of dividend policies are discussed as follows:

(a) Regular Dividend Policy: Payment of dividend at usual rate is termed as regular Dividend. The investors such as retired persons, widows, and other economically weaker persons prefer to get regular dividends. A regular dividend offer following Advantages.

  • It establishes profitable record of company.
  • It creates confidence among shareholder.
  • It stabilises market value of shares
  • It aids in long term financing and renders financing easier.
  • The ordinary shareholders view dividends as a source of founds to meet their day-to-day living expenses.

Regular dividend can be maintained only by companies of long standing and stable earnings.

(b) Stable Dividend Policy: The term ‘Stability of Dividend’ means consistency or lack of variability in stream of dividend payments. A stable dividend policy may be established in any of following three forms.

            (i) Constant Dividend Per Share: Some companies follow a policy of paying fixed dividend per share irrespective of level of earnings year after year. Such firms usually create a ‘Reserve for Dividend Equalisation’ to enable them pay fixed dividend even in year when earnings are not sufficient or when there are losses. A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain stable over number of years.

            (ii) Constant Pay out ratio: It means payment of fixed percentage of net earnings as dividends every year. The amount of dividend in such a policy fluctuates in direct proportion to earnings of company. The policy of constant pay out is preferred by the firms because it is related to their ability to pay dividends.

            (iii) Stable rupee Dividend plus extra dividend: Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profit. Such a policy is most suitable to the firm having fluctuating earnings from year to year.

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

Advantages of Stable Dividend Policy:  A Stable dividend policy is advantageous to both investors and company on account of the following:

(a)    It is sign of continued normal operations of company.

(b)   It stabilises market value of shares.

(c)    It creates confidence among investors.

(d)   It improves credit standing and making financing easier.

(e)    It meets requirements of institutional investors who prefer companies with stable dividends.

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

Dangers of Stable dividend policy

Inspite of many advantages, the stable dividend policy suffers from certain limitations. Once a stable dividend policy is followed by a company, it is not easier to change it. If stable dividends are not paid to shareholders on any account including insufficient profits, the financial standing of company in minds of investors is damaged and they may like to dispose of their holdings. It adversely affects the market price of shares of the company. And if companies pays stable dividends inspite of its incapacity it will be suicidal in long run.

( c)  Irregular Dividend Policy:  Some companies follow irregular dividend payments on account of following:

(a)    Uncertainty of Business.

(b)   Unsuccessful Business operations

(c)    Lack of liquid resources.

(d)   Fear of adverse effects of regular dividend on financial standing of company.

(d) No Dividend Policy: A company may follow a policy of paying no dividends presently because of its unfavourable working capital position or on account of requirements of funds for future expansion and growth.

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

Forms of Dividend

Dividends can be classified in various forms. Dividend paid in ordinary course of business are known as Profit Dividends, while dividends paid out of capital are known as Liquidation dividends. Dividend may also be classified on the basis of medium in which they are paid:

(a)      Cash Dividend: A cash dividend is a usual method of paying dividends. Payment of dividend in cash results in outflow of funds and reduces the company’s net worth, though the shareholder get an opportunity to invest the cash in any manner they desire. This is why ordinary shareholders prefer to receive dividends in cash. But the firm must have adequate liquid resources at its disposal or provide for such resources so that its liquidity position is not adversely affected on account of cash dividends.

(b)      Scrip or Bond Dividend: A scrip dividend promises to pay shareholders at 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 shareholders. The objective of scrip dividend is to postpone the immediate payment of cash. A scrip dividend bears interest and is accepted as a collateral security.

(c)       Property Dividend: Property dividends are paid in the form of some assets other than cash. They are distributed under exceptional circumstances and are not popular in India.

(d)      Stock Dividend: Stock Dividend means the issue of bonus shares to the existing shareholders. If a company does not have liquid resources it is better to declare stock dividend. Stock dividend amounts to capitalisation of earnings and distribution of profits among existing shareholders without affecting the cash position of the firm.

Types of Dividend Polices in Practice for Financial Management and Policy Mcom Sem 2 Delhi University

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