Dividend Types and Policy
Dividend Policy
Dividend policy is a method or technique or approach by the management of
the firm towards some constant payment to the shareholders out of the profits
of the company. Dividend decisions, may be for a short-term purpose, also
called ad-hoc decisions or may be made for a longer-term period.
A dividend policy should be made by the management with certain
consideration in mind. It should take into account the position of the firm and
the economic environment and type of industry in which it operates.
It should also take into consideration the needs of the shareholders in the
present position of the market and other considerations with regard to capital
gain, capital increase and maintenance of levels once achieved.
Apart from this, the consideration of tax should also be thought of
Dividend policy should also be oriented towards the firm’s considerations, its
need for future expansion, business cycle operating in the industry and the
nature of business through which the firm operates.
Determinants of Dividend Policy:
The determinants of a dividend policy should be towards regularity of
income, stability of income, and safety during the period of contingencies. The
legal constraints should also be looked upon by the directors.
The determinants of the dividend policy should project the following
factors:
i. Regular Dividend Payments:
Regularity of dividends is significant for an investor, who wishes to make
purchase of shares in a company. The confidence of investors is increased by
taking a look at the past behaviour of companies. A regular dividend
establishes the company’s position in the stock market.
It also provides a firm policy for taking decisions about the future of the
firm with regard to its expansion programs. It also infuses strength and
confidence in the minds of creditors and it makes it easier for the firm to
take loans from creditors on the strength of its regularity of dividends.
Firms who pay a regular dividend should be careful to maintain it at a rate
that they are able to achieve every year. If the rate goes down the firm’s
position in the stock market also falls.
If too high a dividend is declared the firm may not be able to achieve the
same rate in the forthcoming years. If a company maintains a regular balance in
paying dividends, it will be established and the investor can also plan to make
his investments for a fairly long time.
ii. Stability of Dividends:
In addition to dividends being paid regularly to shareholders, stability of
income through dividends also play a major role for the satisfaction of the
shareholders for the following reasons:
Information:
When a shareholder receives stable dividend, the information about their
shares are continuously received by the stock exchange. This gives the investor
a chance to know about the future of the company. It is also able to influence
a larger number of investors to continue to keep their funds in that particular
firm.
Current Income:
Shareholders, when they invest in a particular company, desire not only
capital gains but also current income from the company. A large number of
investors believe that income received currently from the company in which they
invest is a supplement to their income received from salary and other sources.
This also helps in making decisions for them so that they part with some of
their money which is useful for current consumption and forego it for the
purpose of another investment which would give them income annually. The
investor can also sell his investment from one firm to another but there are many
types of costs involved in it.
Costs are due to transaction or due to switching over. There may be an
element of brokerage cost also. To avoid these costs, the investor would like
stable income so that he may continue to be a long-term investor in one firm
only.
Legal Aspect:
Legally, a stable dividend has many advantages. It gives to the
institutional investors like financial institutions chance to qualify for
investment in their corporate organizations.
One of the considerations of the investment policy of the large number of
financial institutions existing in India is that income should be stable over
the previous years. If the firm satisfies these conditions, the financial
institutions like Life Insurance Corporation of India and Unit Trust of India would
prefer such a company to make their investments.
iii. Regular and Extra Dividend:
A company should have a policy of giving both regular incomes to its
shareholders plus extra dividends whenever the firm is able to do well. An
extra dividend in the form of interim dividend is a good policy because the
interim dividend is not an expectation of the investors and when he receives it
he is rather optimistic about the future of the company without expecting more
than the stable regular income.
Extra income need not be declared annually but only when the company can
make an extra earning. This gives the advantage to the investor to share in the
growth of the company without making it a legal restraint for continuous annual
payments.
iv. Liquidity:
The company should be careful while declaring dividend not to jeopardize
the earning capacity of the firm. Liquidity is an important criterion for the
working of the firm. It is important to declare dividend only after maintaining
liquidity position of the firm.
The company should not have too much liquidity because this means that it
is not profitability investing its funds for shareholders. Proper liquidity
relationship in a firm will also help to safeguard the funds of the
shareholders.
The firm may, however maintain less liquidity after it has the ability to
borrow at short notice or if the financial institutions extend credit whenever
it has a demand for it. Small companies should have a proper liquidity but
large companies which are well established may be flexible about liquidity
requirements because they are in a better position to get liquidity from the
capital markets.
v. Target Pay-Out Ratio:
While declaring dividends that amount should be paid to the shareholders
which can be maintained by the company. If the earning position of the firm
goes down and it cannot pay the dividends in a particular year, then its
position in the stock market will also go down. The pay-out ratio is rate of
dividends to earnings.
Although the amount will fluctuate in direct proportion to earnings, the
shareholders will be satisfied because if a company adopts 20% pay-out ratio
for every year then although the percentage will continue to be the same the
rupee earned will be higher.
For example, if the company pays pay-out ratio of 40% and if it earns Rs.
1.50 per share, the dividend per share will be 60 paise. If it earns Rs. 2 per
share, the dividend given to shareholders will be 80 paise. The earnings will,
therefore, increase for the shareholders although the target pay-out ratio will
be the same.
Dividend Types
The important types of
dividends issued by a company. The types are:
1. Cash Dividends
2. Stock Dividends
3. Scrip Dividend
4. Bond Dividend
5. Property Dividends.
6. Special Dividend
7. Optional
Dividend
8. Depreciation
Dividend
9. Dividends from
Capital Surplus
10. Dividend from
Appreciation
11. Liquidation
Dividend
12. Interim
Dividend.
1. Cash Dividends:
Cash
dividends are, by far, the most popular form of dividend. In cash dividends,
stockholders receive checks for the amounts due to them. Cash generated by
business earnings is used to pay cash dividends. Sometimes, the firm may issue
additional stock to use proceeds so derived to pay cash dividends or bank may
be approached for the purpose. Generally, stockholders have strong preference
for cash dividends.
2. Stock Dividends: Bonus Shares
Stock
dividends rank next to cash dividends in respect of their popularity. In this
form of dividends, the firm issues additional shares of its own stock to the
stockholders in proportion to the number of shares held in lieu of cash
dividends. The payment of stock dividends does not affect cash and earning
position of the firm nor is ownership of stockholders changed.
Indeed
there will be transfer of the amount of dividend from the surplus account to
the capital stock account which tantamount to capitalization of retained
earnings. The net effect of this would be an increase in number of shares of
the current stockholders but there will be no change in their total equity.
With
payment of stock dividends the stock-holders have simply more shares of stock
to represent the same interest as it was before issuing stock dividends. Thus,
there will be merely an adjustment in the firm’s capital structure in terms of
both the book value and the market price of the common stock.
The following example will
illustrate the effect of stock dividends.
Illustration 1:
The Style Construction Company
had the following capital structure before issuing a stock dividend:
The
management issues additional stock of 10,000 shares to pay dividends @ 5
percent. Market price of the stock is Rs. 20 a share. For each 20 shares of
stock owned, the stockholder receives one additional share.
The capital structure after the
issue of stock dividends will stand as under:
With
issue of additional stock of 10,000 shares amount worth Rs. 2,00,000 Rs. 20 x
10,000 shares) is transferred from retained earnings account to Common Stock
and Capital Surplus accounts. Since the par value of additional shares remains
the same, Common Stock Capital would increase by Rs. 50,000 to Rs. 10,50,000.
The
residual of Rs. 1,50,000 goes into Capital Surplus account. Thus net worth of
the Company remains what it was before the issue of stock dividends.
As
a result of the adjustment in capital structure of the Company due to issue of
stock dividends, earnings per share will tend to decline exactly in the
proportions by which total number of shares increased. Assume, for example, the
company had earnings of Rs. 50,00,000.
The
earnings per share before issue of stock dividends would be then Rs. 250. Issue
of stock dividends will result in drop in earnings per share. Thus, with issue
of additional stocks of 10,000 shares earnings per share will fall to Rs. 2.38
(Rs. 5,00,000/2,10,000).
However,
total earnings available to a stockholder would remain unaffected because
earnings per share decreased exactly in proportion to increase in number of
shares of the stockholder.
Guidelines on Stock Dividends
Bonus Shares:
While
announcing stock dividends, the management must keep in mind legal provisions
regarding the distribution of such dividends and also guidelines prescribed by
the controller of capital issues in respect thereof Section 205 (i) of the
Companies Act, 1956, as amended from time to time, lays down certain guidelines
which must be complied with while distributing stock dividends.
These are:
(1)
Articles of association must permit issue of bonus shares.
(2)
Sufficient undistributed profits must be present.
(3)
A resolution capitalizing profits must have been passed by the Board of
Directors.
(4)
The resolution of the Board of Directors must be approved by the stockholders
in a general meeting.
(5)
The bonus issue is permitted to be made out of free reserves built out of
genuine profits or share premium collected in cash only.
(6)
Reserves created by revaluation of fixed assets are not permitted to be
capitalized.
(7)
Development rebate reserve is considered as free reserve for the purpose of
calculation of residual reserves and is also allowed to be capitalized.
(8)
The residual reserves after the proposed capitalisation should be at least 40%
of the increased paid-up capital.
(9)
Thirty percent of the average profits before tax of the company for the
previous three years should yield a rate of dividend on the expanded capital
base of the company at 10%.
(10)
Declaration of bonus issues in lieu of dividend is not allowed.
(11)
The company should make a further application for an issue of bonus shares only
after 24 months have elapsed from the date of sanction by the Government of an
earlier bonus issue by the Company.
(12)
Bonus issues are not permitted unless the partly paid shares, if any, are made
fully paid-up.
(13)
Companies defaulting in payment to any public financial institution will have
to produce a no objection letter from it before issuing bonus shares.
(14)
The amount of reserves to be capitalized by issuing bonus shares should not
exceed the total amount of the paid-up capital of the company.
SEBI Guidelines:
(i)
Issue of bonus shares after any public/rights issue is subject to the conditions
that no bonus issue shall be made which will dilute the value or rights of the
holders of debenture, convertible fully or partly.
In
other words, no company shall, pending conversation of FCDs/PCDs, issue any
shares by way of bonus unless similar benefit is extended to the holders of
such FCDs/PCDs, through reservation of shares in proportion to such convertible
part of FCDs or PCsD. The shares so reserved may be issued at the time of
conversion of such debentures on the same terms on which the bonus shares were
made.
(ii)
Bonus share is made out of free reserves built out of the genuine profits or
share premium collected in cash only.
(iii)
Reserves created by revolution are not capitalized.
(iv)
The declaration of bonus issue in lien of dividend is not made.
(v)
The bonus issue is not made unless the partly paid up shares, if any, are made
fully paid-up.
(vi)
The Company:
(a)
Has not defaulted in payment of interest or principal in respect of fixed
deposits and interest on existing debentures or principal on redemption
thereof, and
(b)
Has sufficient reason to believe that it has not defaulted in respect of the
payment of statutory dues of the employees such as contribution to provident
fund, gratuity, bonus, etc.
(vii)
A company which announces its bonus issue after the approval of the Board of
Directors must implement the proposals within a period of six months from the
date of such approval and shall not have the option of changing the decision.
(viii)
There should be a provision in the Articles of Association of the company for
capitalisation of reserves, etc and if not, the company shall pass a resolution
at its General Body Meeting making provisions in the Articles of Association
for capitalisation.
(ix)
Consequent to the issue of bonus shares if the subscribed and paid-up capital
exceeds the authorised share capital, a resolution shall be passed by the
company at its General Body Meeting for increasing the authorised capital.
3. Scrip Dividend:
Scrip
dividend means payment of dividend in scrip or promissory notes. Sometimes
companies need cash generated by business earnings to meet business
requirements or withhold the payment of cash dividend because of temporary
shortage of cash.
In
such cases the company may issue scrip or notes promising to pay dividend at a
future date. The scrip usually bears a definite date of maturity. Sometimes
maturity date is not stipulated and its payment is left to the discretion of
Board of Directors. Scrip may be interest bearing or non-interest bearing. Such
dividends are relatively scarce.
Issue of scrip dividends is
justified in the following circumstances:
(i)
When a company has sufficiently large earnings to distribute dividends but cash
position is temporarily tight because bulk of the sale proceeds tied in receivables
for time being will be released very shortly, the management may issue
certificates to stockholders promising them to pay dividend in near future.
(ii)
When a company wants to maintain an established dividend record without paying
out cash immediately, the management may take recourse to scrip dividend.
(iii)
When the management believes that stock dividend will not be useful because
future earnings of the company will not increase sufficiently to maintain
dividend rate on increased shareholding, issue of promissory notes to pay
dividends in future would be a wise step.
(iv)
When the company does not wish to borrow to cover its dividend. The danger lies
in their use as a sop to stockholders when business earnings are inadequate to
cover dividend payments. Such kind of dividend is not in existence in India.
4. Bond Dividend:
As
in scrip dividends, dividends are not paid immediately in bond-dividends;
instead company promises to pay dividends at future date and to that effect
issues bonds to stockholders in place of cash. The purpose of both bond and
scrip dividends is alike, i.e. postponement of dividend payment.
Difference
between the two is in respect of date of payment and their effect is the same.
Both result in lessening of surplus and in addition to the liability of the
firm. The only difference between bond and scrip dividends is that the former
carries longer maturity date than the latter.
Thus,
while issue of bond-dividend increases long-term obligation of the Company,
current liability increases as consequence of issue of scrip dividends. In bond
dividends stockholders have stronger claim against the company as compared to
scrip dividends.
Bonds
used to pay dividends always carry interest. This means that company assumes
fixed obligation of interest payments annually on principal amount of bond at
the maturity date. It should be remembered that the company is assuming this
obligation in return of nothing except credit for declaring the dividend.
How
far the company will be able to meet this obligation in future is also
difficult to predict at the time of issue of bonds.
Management
should, therefore, balance cost of issuing bond dividends against benefits
resulting from them (benefit of the bond dividend lies in postponement of
dividend for a distant date) before deciding about distribution of dividends in
the form of bonds. Bond dividends are not vogue in India.
5. Property Dividends:
In
property dividends, Company pays dividends in the form of assets other than
cash. Generally, assets that are superfluous for the Company are distributed as
dividends to stock-holders. Sometime, a Company may use its products to pay
dividends. Securities of subsidiaries owned by the Company may also take the
form of property dividends. This form of dividend is not vogue in India.
6. Special Dividend:
When cash dividend cannot be declared because the
company is making efforts to retrench its operations then it gives a special
dividend as a return of capital to the shareholders in a gradual manner.
7. Optional Dividend:
Optional dividend is a method of payment of dividend
either through cash or through stock. If a cash dividend is not possible to be
given because the firm has gone into expansion, it may arrive at the policy of
giving of stock dividend.
8. Depreciation Dividend:
When companies reduce their capital they give a small
amount to the shareholders as dividend. In some form, the company wipes out its
deposit and is able to create a surplus for the continuation of the payment of
its dividend.
Depreciation dividends are not a good policy by a
company. These are not allowed in India.
9. Dividends from Capital
Surplus:
Cash dividend from the current sources of income is the
best method of paying for investment in a company. But sometimes the company
also makes its payments of dividend out of capital.
Dividends from capital surplus
can be paid to the shareholders only:
(a) When the company’s Memorandum of Association and
Articles of Association permit it do so,
(b) When such profits are received in the form of cash,
(c) After revaluation of assets some surplus is left,
(d) The dividend distributed in this manner from
capital surplus does not affect the creditors of the firm.
10.
Dividend from Appreciation:
Sometimes, assets are sold by the firm and the price
received by the firm is higher that the book value. The company may decide to
pay dividends out of the appreciation.
11. Liquidation Dividend:
When a company fails or is dissolved then at the time
of liquidation, if some distribution is made out of assets it is the
distribution of dividend from liquidation. This liquidation dividend is first
paid to the bondholders, debenture holders and preference shareholders. When
claims of creditors are satisfied, the equity shareholder may also be given an
amount of such dividend.
The investor should bear in mind that there are several
sources for a firm to make the payment of dividends. The firm can pay the
dividends from its current earnings which arise out of the regular operations
of the firm.
It may also pay all dividends from the past
accumulation of profits. The firm is also permitted to pay dividend, out of the
income from its subsidiaries. In addition, the firm is sometimes allowed to pay
dividends out of other sources, but only under certain important
considerations.
These sources may be from the sale of a property, price
of the sale being higher than the book value. It may also be paid out of the
sale of securities at a premium and by conversion of some unused resources.
When a company makes a surplus from mergers or purchase of subsidiaries, it may
also declare a dividend.
12. Interim Dividend:
Interim dividend is the income of the previous year in
which the amount of such dividend is unconditionally made available by the
company to a shareholder. It is paid between two annual dividends. It can be
paid when the company is making a high profit.
13.Right Shares of Shareholder
In case of Right Shares, the shareholder has the right
to avail the ‘Right’ himself or he can refer it to a third party. The face
values of such right shares are recorded in the Nominal Column and the amount
so paid is this regard is to be recorded in the Principal Column. But in case
of sale, the amount so received against the sale of Right will be entered on
the credit side of Investment Account in Principal Column.
It is needless to say that if Right shares are offered
by the company and, consequently, subscribed for, the cost of right shares will
be added to the cost of original holdings to find out the total cost/carrying
cost of investments.
Relevance of Dividend and
Irrelevance of Dividend
Dividend and market price of shares are interrelated.
However, there are two schools of thought: while one school of thought opines
that dividend has an impact on the value of the firm, another school argues
that the amount of dividend paid has no effect on the valuation of firm.
The first school of thought refers to the Relevance of
dividend while the other one relates to the Irrelevance of dividend.
Relevance of Dividend:
Walter and Gordon suggested that shareholders prefer
current dividends and hence a positive relationship exists between dividend
and market value. The logic put behind this argument is that investors are
generally risk-averse and that they prefer current dividend, attaching lesser
importance to future dividends or capital gains.
1.
Walter’s model:
Professor James E. Walterargues that the choice of
dividend policies almost always affects the value of the enterprise. His model
shows clearly the importance of the relationship between the firm’s internal
rate of return (r) and its cost of capital (k) in determining the dividend
policy that will maximise the wealth of shareholders.
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.
Walter’s formula to determine
the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
The above equation clearly
reveals that the market price per share is the sum of the present value of two
sources of income:
i) The present value of an infinite stream of constant
dividends, (D/K) and
ii) The present value of the infinite stream of stream
gains.
[r (E-D)/K/K]
Criticism:
Walter’s model is quite useful to show the effects of
dividend policy on an all equity firm under different assumptions about the
rate of return. However, the simplified nature of the model can lead to
conclusions which are net true in general, though true for Walter’s model.
The criticisms on the model are
as follows:
1. Walter’s model of share valuation mixes dividend
policy with investment policy of the firm. The model assumes that the
investment opportunities of the firm are financed by retained earnings only and
no external financing debt or equity is used for the purpose when such a
situation exists either the firm’s investment or its dividend policy or both
will be sub-optimum. The wealth of the owners will maximise only when this
optimum investment in made.
2. Walter’s model is based on the assumption that r is
constant. In fact decreases as more investment occurs. This reflects the
assumption that the most profitable investments are made first and then the
poorer investments are made.
The firm should step at a point where r = k. This is
clearly an erroneous policy and fall to optimise the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does
not remain constant; it changes directly with the firm’s risk. Thus, the
present value of the firm’s income moves inversely with the cost of capital. By
assuming that the discount rate, K is constant, Walter’s model abstracts from
the effect of risk on the value of the firm.
Comments:
(a) In case of a growth firm, i.e. a firm having a rate
of return higher than the cost of capital, market price per share is inversely
related to dividend pay-out ratio. Decrease in dividend pay-out leads to
increase in market price per share. The market price per share is maximum when
dividend pay-out ratio is zero.
(b) In case of a normal firm, i.e. a firm having rate
of return equal to the cost of capital, market price per share remains constant
irrespective of dividend pay-out and hence there is no optimum dividend pay-out
ratio.
(c) In case of a declining firm, i.e. a firm having
rate of return less than the cost of capital, market price per share is
directly related with dividend pay-out ratio. Increase in dividend pay-out,
increases the market price and the market price is maximum when dividend
pay-out ratio is 100%.
2.
Gordon’s Model:
One very popular model explicitly relating the market
value of the firm to dividend policy is developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
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.
According to Gordon’s dividend capitalisation model,
the market value of a share (Pq) is equal to the present value of an infinite
stream of dividends to be received by the share. Thus:
The above equation
explicitly shows the relationship of current earnings (E,), dividend policy,
(b), internal profitability (r) and the all-equity firm’s cost of capital (k),
in the determination of the value of the share (P0).
Irrelevance of Dividend:
As per Irrelevance Theory of Dividend, the market price
of shares is not affected by dividend policy. Payment of dividend does not
change the wealth of the existing shareholders because payment of dividend
decreases cash balance and their share price falls by that amount. Franco
Modigliani and Merton Miller, two Nobel-laureates developed this model in the
year 1961.
1.
Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend
policy of a firm is irrelevant as it does not affect the wealth of the
shareholders. They argue that the value of the firm depends on the firm’s earnings
which result from its investment policy.
Thus, when investment decision of the firm is given,
dividend decision the split of earnings between dividends and retained earnings
is of no significance in determining the value of the firm. M – M’s hypothesis
of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty
does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all
securities and all time periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the
discount rate and identical for all shares. As a result, the price of each
share must adjust so that the rate of return, which is composed of the rate of
dividends and capital gains, on every share will be equal to the discount rate
and be identical for all shares.
Thus, the rate of return for a
share held for one year may be calculated as follows:
Where P^ is the market or purchase price per share at
time 0, P, is the market price per share at time 1 and D is dividend per share
at time 1. As hypothesised by M – M, r should be equal for all shares. If it is
not so, the low-return yielding shares will be sold by investors who will
purchase the high-return yielding shares.
This process will tend to reduce the price of the
low-return shares and to increase the prices of the high-return shares. This
switching will continue until the differentials in rates of return are
eliminated. This discount rate will also be equal for all firms under the M-M
assumption since there are no risk differences.
From the above M-M fundamental principle we can derive
their valuation model as follows:
Multiplying both sides of equation by the number of
shares outstanding (n), we obtain the value of the firm if no new financing
exists.
The above equation of M – M valuation allows for the
issuance of new shares, unlike Walter’s and Gordon’s models. Consequently, a
firm can pay dividends and raise funds to undertake the optimum investment
policy. Thus, dividend and investment policies are not confounded in M – M
model, like waiter’s and Gordon’s models.
Criticism:
Because of the unrealistic nature of the assumption,
M-M’s hypothesis lacks practical relevance in the real world situation. Thus,
it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from
reality.
2. M-M argue that the internal and external financing
are equivalent. This cannot be true if the costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a
shareholder will be same whether the firm pays dividends or not. But, because
of the transactions costs and inconvenience associated with the sale of shares
to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not
correct to assume that the discount rate (k) should be same whether firm uses
the external or internal financing.
If investors have desire to diversify their port
folios, the discount rate for external and internal financing will be
different.
5. M-M argues that, even if the assumption of perfect
certainty is dropped and uncertainty is considered, dividend policy continues to
be irrelevant. But according to number of writers, dividends are relevant under
conditions of uncertainty.
Dividend Practices in India
Some of the important dividend practices are: 1. A Fixed Rupee Amount of
Dividend 2. Minimum Rupee amount with a step-up Feature 3. Fixed Percentage of
Net Profit and 4. Dividends as a Fixed Percentage of Market Value.
1. A Fixed Rupee Amount of Dividend:
This policy emphasises the significance of regularity in dividends of a
given size above everything else. Under this policy, there is no connection
between dividends paid and current profits earned.
This policy tends to treat ordinary shareholders somewhat like preference
shareholders and gives no particular consideration to the role played by the
investment of retained earnings. The danger in using this policy is that if the
dividend payments are too large and it takes a large portion of accumulated
working capital, the company may not be able to withstand the shock of
operating losses.
2. Minimum Rupee amount with a step-up Feature:
This policy is based on the proposal that the present shareholders want a
regular rupee amount as dividend, however small it may be. But corporate
profits are given more consideration in determining the dividends in this
policy as compared to the policy mentioned above.
The small amount of the fixed dividend aims at reducing the chance of ever
missing a dividend. This policy sets the dividend low enough so that there is
little chance of a default but at the same time it allows a great deal of flexibility
for paying higher dividends and does commit the business to adopt the larger
dividend may or may not be distributed depending on the capital growth plans of
the management.
The emphasis is placed on internal financing and on establishing a broad
foundation of equity capital for future borrowing. This is a popular policy for
companies with fluctuating incomes because it provides managers with a policy
guide without seriously restricting their freedom of decision-making.
Certain shareholders also like it because it allows them to plan on fixed
amounts of cash and at the same time there is possibility of getting a reward
by way of internal growth of their investment and possibly by higher market
values for their shares when profits increase.
3. Fixed Percentage of Net Profit:
This is the most flexible dividend policy as it is related directly to net
profits. Under this policy, dividends are a fixed percentage of profits which
is called as the payout ratio and will fluctuate at exactly the same rate as
profits. The first impulse may be to start a policy of this type because it is
related to the ability to pay, measured by profits. But this policy leaves
management with limited freedom for decision- making.
Internal financing with retained earnings becomes automatic and inverse to
the payout ratio. For example, a 60% payout is a 40% pay in ratio and a 30%
payout is a 70% pay in ratio. At any given payout ratio, the rupee amount of
dividends and the rupee additions to retained earnings will both increase with
the increasing rupee profits and decrease with decreasing rupee profits.
Policy requiring the distribution of dividend as a fixed percentage of net
profits will provide a good amount of retained earnings in a profitable and
growing business and make it easier to finance in the future as creditors and
preference shareholders will be willing to extend funds on the prospect of an
increase in equity.
But the picture will be different if the profits are declining. Therefore,
it may be better in the interests of shareholders in the long run that
corporate management increases the percentage of dividends when profits decline
and decrease it as profits increase.
4. Dividends as a Fixed Percentage of Market Value:
As shareholders often translate their dividend income into the percentage
returns of market price of their shares, financial managers, should relate
dividends to the value of company’s shares rather than to its profits. This
requires first determining a typical rate of dividend return as a target rate.
The target may be the average dividend for the industry or it may be the
rate paid by a closely competitive company. This policy singles out the market
as the ideal valuation mechanism. No consideration is given here to the effect
of dividends on internal investment conditions, or on prospects for future
financing. It is based on the belief that management owned an obligation to the
shareholders to adjust dividend payment with the rates paid by competitors and
by the industry as a whole on their market investment values.
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