Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – The Dividend Policy is a financial decision that refers to the proportion of the firm’s earnings to be paid out to the shareholders. Here, a firm decides on the portion of revenue that is to be distributed to the shareholders as dividends or to be ploughed back into the firm.
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – The objective of the course is to acquaint the students with the basic analytical techniques and methods of financial management of business firms. The course also provides students the exposure to certain sophisticated and analytical techniques that are used for taking financial policy decisions.
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University contains following topics.
Dividend Policy: Dividend and its form; cash dividend, right and bonus shares, and buy-back of shares; theories of dividend policy and their impact on the value of a firm; types of dividend policy-constant pay-out ratio and constant dividend amount policies; determinants of dividend policy and some case studies
Dividend and its form for Financial Management
There are various forms of dividends that are paid out to the shareholders:
- Cash Dividend
- Bonus Shares
- Share Repurchase
- Property Dividend
- Scrip Dividend
- Liquidating Dividend
Types of Dividend Policy:
The various types of dividend policies are discussed as follows:
(a) Regular Dividend Policy: in this type of dividend policy the investors get dividend at usual rate. Here the investors are generally retired persons or weaker section of the society who want to get regular income. This type of dividend payment can be maintained only if the company has regular earning.
(b) Stable Dividend Policy: Here the payment of certain sum of money is regularly paid to the shareholders
A stable dividend policy may be established in any of the following three forms:
(i) Constant dividend per share:
(ii) Constant payout ratio:
(iii) Stable rupee dividend plus extra dividend:
(c) Irregular dividend : As the name suggests here the company does not pay regular dividend to the shareholders. The company uses this practice due to following reasons:
- Due to uncertain earning of the company.
- Due to lack of liquid resources.
- The company sometime afraid of giving regular dividend.
- Due to not so much successful business.
(d) No dividend: the company may use this type of dividend policy due to requirement of funds for the growth of the company or for the working capital requirement.
Theories of dividend policy and their impact on the value of a firm
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Over the time various theories of dividend policy have emerged; some of the main theories are as follows:
The Residual Theory of Dividend Policy The residual theory of dividend policy holds that the firm will only pay dividend from residual earnings, that is dividends should be paid only if funds remain after the optimum level of capital expenditures is incurred i.e. all suitable investment opportunities have been financed. With a residual dividend policy, the primary focus of the firm is on investments and hence dividend policy is a passive decision variable. The value of a firm is a direct function of its investment decisions thus making dividend policy irrelevant
Dividend Irrelevancy Theory, (Miller & Modigliani, 1961) The dividend irrelevancy theory asserts that dividend policy has no effect on either the price of the firm or its cost of capital. Dividend Irrelevance Arguments Dividend policy does not affect share price because the value of the firm is a function of its earning power and the risk of its assets. If dividends do affect value, it is only due to: a) Information effect : The informational content of dividends relative to management’s earnings expectations b) Clientele effect: A clientele effect exists which allows firms to attract shareholders whose dividend preferences match the firm’s historical dividend payout patterns.
The Bird in the Hand Theory, (John Lintner 1962 and Myron Gordon, 1963) The essence of this theory is not stockholders are risk averse and prefer current dividends due to their lower level of risk as compared to future dividends. Dividend payments reduce investor uncertainty and thereby increase stock value. This theory is based on the logic that ‘ what is available at present is preferable to what may be available in the future’. Investors would prefer to have a sure dividend now rather than a promised dividend in the future (even if the promised dividend is larger). Hence dividend policy is relevant and does affect the share price of a firm.
The Tax Differential Theory, (B. Graham and D.L. Dodd) This theory simply concludes that since dividends are taxed at higher rates than capital gains, investors require higher rates of return as dividend yields increase. This theory suggests that a low dividend payout ratio will maximize firm value.
Percent Payout Theory (Rubner 1966)25 Rubner (1966) argued that shareholders prefer dividends and directors and managers requiring additional finance would have to convince the investors that proposed new investments would increase their wealth. However to increase their job security and status in the eyes of the shareholders companies can adopt 100 per cent payout. However this policy is not followed in practice
Per Cent Retention Theory (Clarkson and Eliot 1969) Clarkson and Eliot (1969) argued that given taxation and transaction costs dividends are a luxury that is not afforded by shareholders as well as by companies and hence a firm can follow a policy of 100 per cent retention. Firms can thus avail of new investment opportunities that would be beneficial to shareholders too.
Agency Cost Theory (Jenson)27, 28 Since Jenson and Meckling (1976), many studies have provided arguments that link agency costs with the other financial activities of a firm. It has been argued that firms payout dividends in order to reduce agency costs. Dividend payout keeps firms in the capital market, where monitoring of managers is available at lower cost. If a firm has free cash flows (Jensen (1986), it is better off sharing them with stockholders as dividend payout in order to reduce the possibility of these funds being wasted on unprofitable (negative net present value) projects. This modern view of dividend policy emphasizes the valuable role of dividend policy in helping to resolve agency problem and thus in enhancing shareholder value.
Determinants of dividend policy and some case studies
10 Most Important Determinants of Dividend Policy
(i) Type of Industry:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Industries that are characterized by stability of earnings may formulate a more consistent policy as to dividends than those having an uneven flow of income. For example, public utilities concerns are in a much better position to adopt a relatively fixed dividend rate than the industrial concerns.
(ii) Age of Corporation:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Newly established enterprises require most of their earning for plant improvement and expansion, while old companies which have attained a longer earning experience, can formulate clear cut dividend policies and may even be liberal in the distribution of dividends.
(iii) Extent of share distribution:
A closely held company is likely to get consent of the shareholders for the suspension of dividends or for following a conservative dividend policy. But a company with a large number of shareholders widely scattered would face a great difficulty in securing such assent. Reduction in dividends can be affected but not without the co-operation of shareholders.
(iv) Need for additional Capital:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – The extent to which the profits are ploughed back into the business has got a considerable influence on the dividend policy. The income may be conserved for meeting the increased requirements of working capital or future expansion.
(v) Business Cycles:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – During the boom, prudent corporate management creates good reserves for facing the crisis which follows the inflationary period. Higher rates of dividend are used as a tool for marketing the securities in an otherwise depressed market.
(vi) Changes in Government Policies:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Sometimes government limits the rate of dividend declared by companies in a particular industry or in all spheres of business activity. The Government put temporary restrictions on payment of dividends by companies in July 1974 by making amendment in the Indian Companies Act, 1956. The restrictions were removed in 1975.
(vii) Trends of profits:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – The past trend of the company’s profit should be thoroughly examined to find out the average earning position of the company. The average earnings should be subjected to the trends of general economic conditions. If depression is approaching, only a conservative dividend policy can be regarded as prudent.
(viii) Taxation policy:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Corporate taxes affect dividends directly and indirectly— directly, in as much as they reduce the residual profits after tax available for shareholders and indirectly, as the distribution of dividends beyond a certain limit is itself subject to tax. At present, the amount of dividend declared is tax free in the hands of shareholders.
(ix) Future Requirements:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Accumulation of profits becomes necessary to provide against contingencies (or hazards) of the business, to finance future- expansion of the business and to modernise or replace equipments of the enterprise. The conflicting claims of dividends and accumulations should be equitably settled by the management.
(x) Cash Balance:
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – If the working capital of the company is small liberal policy of cash dividend cannot be adopted. Dividend has to take the form of bonus shares issued to the members in lieu of cash payment.
- Dividend payout ratio
- Stability of dividends
- Legal, contractual and internal constraints and restrictions
- Owner’s considerations
- Capital market considerations and
Dividend payout ratio
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm’s shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives maximizing the wealth of the firms owners and providing sufficient funds to finance growth. These objectives are interrelated
Stability of dividends
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:
- constant dividend per share
- constant dividend payout ratio or
- constant dividend per share plus extra dividend
Legal, contractual and internal constraints and restrictions
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control.
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – The dividend policy is also likely to be affected by the owner’s considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership.
Capital market considerations
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
Unit IV Dividend Policy for Financial Management and Policy Mcom sem 2 Delhi University – With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.