DIVIDEND POLICY

6.1 Fundamentals
6.2 Policy theory and arguments
6.3 Factors affecting policy
6.4 Types of policies
6.5 Other forms of dividends
 WHAT IS A DIVIDEND POLICY?
A company’s dividend policy dictates
the amount of dividends paid out by
the company to its shareholders and
the frequency with which the dividends
are paid out. When a company makes
a profit, they need to make a decision
on what to do with it. They can either
retain the profits in the company
(retained earnings on the balance
sheet), or they can distribute the money
to shareholders in the form of
dividends.
 1. REGULAR DIVIDEND POLICY
Under the regular dividend policy, the company pays out dividends to its
shareholders every year. If the company makes abnormal profits (very high profits),
the excess profits will not be distributed to the shareholders but are withheld by the
company as retained earnings. If the company makes a loss, the shareholders will still
be paid a dividend under the policy.

The regular dividend policy is used by companies with a steady cash flow and stable
earnings. Companies that pay out dividends this way are considered low-risk
investments because while the dividend payments are regular, they may not be very
high.
 2. STABLE DIVIDEND POLICY

Under the stable dividend policy, the percentage of profits paid out as dividends is
fixed. For example, if a company sets the payout rate at 6%, it is the percentage of
profits that will be paid out regardless of the amount of profits earned for the
financial year.

Whether a company makes $1 million or $100,000, a fixed dividend will be paid

out. Investing in a company that follows such a policy is risky for investors as the
amount of dividends fluctuates with the level of profits. Shareholders face a lot of
uncertainty as they are not sure of the exact dividend they will receive.
 3. IRREGULAR DIVIDEND POLICY

Under the irregular dividend policy, the company is under no obligation to pay its
shareholders and the board of directors can decide what to do with the profits. If
they make an abnormal profit in a certain year, they can decide to distribute it to the
shareholders or not pay out any dividends at all and instead keep the profits for
business expansion and future projects.

The irregular dividend policy is used by companies that do not enjoy a steady cash
flow or lack liquidity. Investors who invest in a company that follows the policy face
very high risks as there is a possibility of not receiving any dividends during the
financial year.
 4. NO DIVIDEND POLICY

Under the no dividend policy, the company doesn’t distribute dividends to

shareholders. It is because any profits earned is retained and reinvested into the
business for future growth. Companies that don’t give out dividends are constantly
growing and expanding, and shareholders invest in them because the value of the
company stock appreciates. For the investor, the share price appreciation is more
valuable than a dividend payout.
POLICY THEORY AND ARGUMENTS
 1. WHAT IS OPTIMAL DIVIDEND
POLICY?
The optimal dividend policy is
simple:
only distribute dividends when
cash holdings exceed
threshold , which depends on
the state of the economy. This
is done exactly as in the
deterministic interest rate
case. Namely, if the initial
cash holdings exceed , then an
initial dividend is distributed
 OTHER DIVIDEND POLICY ISSUES
▪Clientele Effect: Investors needing current income will be drawn to firms with high
payout ratios. Investors preferring to avoid taxes will be drawn to firms with lower
payout ratios. Therefore, firms should avoid making drastic changes in their dividend
policy.
▪Information Content: Changes in dividend policy may be signals concerning the firm’s
financial condition. A dividend increase may signal good future earnings. A dividend
decrease may signal poor future earnings.
 2. RESIDUAL DIVIDEND THEORY
Retain and reinvest earnings as long
as returns on the investments exceed
the returns stockholders could obtain
on other investments of comparable
risk. This concept is illustrated
graphically below. A corporation
should retain all necessary earnings to
invest up to the level indicated by the
intersection of the MCC (marginal cost
of capital) and IOS (investment
opportunity schedule) functions.
Residual earnings are distributed to
shareholders.
 FACTORS AFFECTING DIVIDEND
POLICY OF A FIRM, BUSINESS AND
COMPANY: EXTERNAL AND
INTERNAL FACTORS
 1. STABILITY OF EARNINGS:
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.
 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.
 5. PAST DIVIDEND RATES:

Ifthe 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.
 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. 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.
10. 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.
 11. TAX POSITION OF
SHAREHOLDERS:
The tax position of shareholders is another influencing factor
on dividend decisions. In a company if a large number of
shareholders have already high income from other sources and
are bracketed in high income structure, they will not be
interested in high dividends because the large part of the
dividend income will go away by way of income tax. Hence,
they prefer capital gains to cash gains, i.e., dividend capital
gains here we mean capital benefit derived by the
capitalisation of the reserves or issue of bonus shares.
 11. TAX POSITION OF
SHAREHOLDERS CONT)
Instead of receiving the dividend in the form of cash (whatever may be the per cent),
the shareholders would like to get shares and increase their holding in the form of
shares. This has certain benefits to shareholders. They get money by selling these
extra shares received in proportion to their original shareholding.

This will be a capital gain for them. Of course, they have to pay tax on capital gains.
But the capital gains tax will be less compared to the income-tax that they should
have paid when cash dividend was declared and added to the personal income of
the shareholders.
 12. 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.
 15. ATTITUDE OF THE INTERESTED
GROUP:
A concern may have certain group of interested and powerful
shareholders. These people have certain attitude towards
payment of dividend and have a definite say in policy
formulation regarding dividend payments. If they are not
interested in higher rate of dividend, shareholders are not
likely to get that. On the other hand, if they are interested in
higher rate of dividend, they will manage to make company
declare higher rate of dividend even in the face of many
odds.
TYPES OF DIVIDEND POLICIES
 STABLE DIVIDEND POLICY

A stable dividend policy is the easiest and most commonly used. The goal of the
policy is a steady and predictable dividend payout each year, which is what most
investors seek. Whether earnings are up or down, investors receive a dividend.

The goal is to align the dividend policy with the long-term growth of the company
rather than with quarterly earnings volatility. This approach gives the shareholder
more certainty concerning the amount and timing of the dividend.
 CONSTANT DIVIDEND POLICY

The primary drawback of the stable dividend policy is that investors may not see a
dividend increase in boom years. Under the constant dividend policy, a company
pays a percentage of its earnings as dividends every year. In this way, investors
experience the full volatility of company earnings.

If earnings are up, investors get a larger dividend; if earnings are down, investors
may not receive a dividend. The primary drawback to the method is the volatility of
earnings and dividends. It is difficult to plan financially when dividend income is
highly volatile.
 RESIDUAL DIVIDEND POLICY

Residual dividend policy is also highly volatile, but some investors see it as the only
acceptable dividend policy. With a residual dividend policy, the company pays out
what dividends remain after the company has paid for capital expenditures (CAPEX)
and working capital.

This approach is volatile, but it makes the most sense in terms of business operations.
Investors do not want to invest in a company that justifies its increased debt with the
need to pay dividends.
 EXAMPLE OF A DIVIDEND POLICY

Kinder Morgan (KMI) shocked the investment world when in 2015 they cut their
dividend payout by 75%, a move that saw their share price tank. However, many
investors found the company on solid footing and making sound financial decisions for
their future. In this case, a company cutting their dividend actually worked in their
favor, and six months after the cut, Kinder Morgan saw its share price rise almost
25%. In early 2019, the company again raised its dividend payout by 25%, a move
that helped to reinvigorate investor confidence in the energy company.
DIVIDENDS – FORMS, ADVANTAGES
AND DISADVANTAGES

Different Forms of Dividends

 CASH DIVIDEND

It is the most common form. The shareholders receive cash for each share. The board
of directors announces the dividend payment on the date of declaration. The
company assigns the dividends to those shareholders who were holding the status of
the shareholder of that company on the date of records. The record date and
ex-dividend date are two very important concepts. The dividends are issued on the
date of payment. But for distributing cash dividends, the company needs to have
positive retained earnings and enough cash for such distributions.
 BONUS SHARE

Bonus shares are also called stock dividends. A company always wishes to keep its
investors happy. When a company has low operating cash, it can distribute dividends
in the form of bonus shares.
Under this, each equity shareholder receives a certain number of additional shares
depending on the number of shares originally owned by the shareholder. For
example, suppose a person possesses 10 shares of Company A, and the company
declares a bonus share issue of 1 for every 2 shares. In that case, the person will get
5 additional shares in his account without any payment. From the company’s angle, the
company’s number of shares and issued capital will increase by 50% (1/2 shares).
The market price, EPS, DPS, etc., will be adjusted accordingly. In this case, the
company shall retain earnings also at the same time; the shareholders get returns. An
investor who desires a cash return can sell the investment in the secondary market. The
term for referring to this is the ‘capitalization of earnings.’
 SHARE REPURCHASE

Share repurchase occurs when a company buys back its own shares from the market
and reduces the number of shares outstanding. This is considered an alternative to the
dividend payment as cash is returned to the investors in another way.
 PROPERTY DIVIDEND

The company makes the payment in the form of assets under the property dividend.
The asset could be any of this equipment, inventory, vehicle, or any other asset. The
asset’s value has to be restated at the fair value while issuing this.
 SCRIP DIVIDEND

It is a promissory note to pay the shareholders later. This form of dividend is used
when the company does not have sufficient funds for such issuance.
 LIQUIDATING DIVIDEND

When the company returns the original capital contributed by the equity shareholders
as a dividend, it is termed a liquidating dividend. It is often seen as a sign of closing
down the company.
Bird-in-Hand Fallacy
Bird in hand theory states that the shareholders prefer the certainty of dividends in
comparison to the possibility of higher capital gains in the future.
Clientele Effect
Suppose a dividend-paying company is unable to pay returns to shareholders for a
certain period of time. In that case, it may result in the loss of old clientele who
preferred regular payments. These investors may sell off the stock in the short term.
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