DIVIDEND POLICY DECISION

UNIT 6

• Meaning

• Theories of Dividend decisions

• Determinants of dividend policy decisions

• Companies Act, 2013 and SEBI guideines on dividend

distribution
 TYPES/FORMS OF DIVIDEND

A. Cash dividend - are common and popular types followed by majority of the business
concerns.

B. Stock dividend : Stock dividend is paid in the form of the company stock may be bonus
issue. This issue is given only to the existing shareholders of the business concern.

C. Bond dividend : Bond dividend is also known as script dividend. If the company does not
have sufficient funds to pay cash dividend, the company promises to pay the shareholder at
a future specific date with the help of issue of bond or notes.

D. Property dividend : Property dividends are paid in the form of some assets other than
cash. It will distribute under the exceptional circumstance. This type of dividend is not
published in India.
• Dividend policy determines what portion of earnings will be
paid out to stock holders and what portion will be retained
in the business to finance long-term growth.
• Both dividend and growth are desirable but are conflicting
goals to each other.
• Higher dividend means less retained earnings and vice
versa.
• Dividend policy involves the balancing of the shareholders’
desire for current dividends and the firm’s needs for funds
for growth.WHAT IS “DIVIDEND POLICY”?

• It’s the decision to pay out earnings versus retaining and

reinvesting them. Includes these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
 TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and profitable
position.
Regular dividend policy : Dividend payable at the usual rate is called as regular dividend
policy. This type of policy is suitable to the small investors, retired persons and others.
Stable dividend policy: Stable dividend policy means payment of certain minimum
amount of dividend regularly. This dividend policy consists of the following three important
forms:
•Constant dividend per share
•Constant payout ratio
•Stable rupee dividend plus extra dividend.
 Irregular dividend policy
No dividend policy.
DO INVESTORS PREFER HIGH OR LOW
PAYOUTS?
 DIVIDEND IRRELEVANCE THEORY

• Modigliani-Miller proposed this theory in 1961

supporting irrelevance.
• Suggests that dividends do not affect a firm’s
value, assuming perfect capital market, no taxes
and no transaction costs.
• Investors are indifferent between dividends and
retention-generated capital gains.
• If the firm’s cash dividend is too big, you can just
take the excess cash received and use it to buy
more of the firm’s stock. If the cash dividend is too
small, you can just sell a little bit of your stock in
the firm to get the cash flow you want.
• Criticism: Theory is based on unrealistic
assumptions (no taxes or brokerage costs), hence
may not be true. Need empirical test.
 BIRD-IN-THE-HAND THEORY

• Investors think dividends are less risky than potential future capital gains, hence

they like dividends.

• Because investors prefer certain dividends today over uncertain future capital

gains.

• If so, investors would value high payout firms more highly, i.e., a high payout

would result in a high P 0.

• Criticism : Ignores the potential for reinvesting earnings into profitable projects.
 WHAT’S THE “INFORMATION CONTENT,” OR
“SIGNALING,” HYPOTHESIS?

• Managers hate to cut dividends, so won’t raise

dividends unless they think raise is sustainable. So,
investors view dividend increases as signals of
management’s view of the future.

• Therefore, a stock price increase at time of a

dividend increase could reflect higher expectations
for future dividends themselves, not to a change in
the dividend payout policy.
 WHAT’S THE “RESIDUAL DIVIDEND MODEL”?

• As per this theory, the amount of dividends paid

to shareholders is equal to the profit amount left
after the company has paid its capital expenditure
(CapEx) and its operating costs (working capital).
• Find the retained earnings needed for the capital
budget.
• Pay out any leftover earnings (the residual) as
dividends only if more earnings are available than
are needed to support the optimal capital budget.
• This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.
• The firm’s value depends on investment policy, not
dividend decisions.
 USING THE RESIDUAL MODEL TO CALCULATE
DIVIDENDS PAID

Net
Dividends = income–
[( )( )]
Target
equity
ratio
Total
capital
budget
.
 WALTER’S MODEL

Walter’s Model was introduced by Prof. James E. Walter.

Assumptions:
•All investment proposals of the firm are to be financed through retained
earnings only.
• ‘r’ rate of return & ‘Ke’ cost of capital are constant.
• Perfect capital markets: The firm operates in a market in which all investors are
rational and information is freely available to all.
• No taxes or no tax discrimination between dividend income and capital
appreciation and No floatation or transaction cost.
The model is based on share valuation and states that both prices of share and
dividends are interdependent.
It demonstrates the relationship between the internal rate of return (r) or returns
on investment with the capital cost (k).
•Suppose the rate of return is greater than the cost of capital (r > k). In that
case, the organisation must hold their earnings to increase investment
opportunities. The organisation will earn more compared to the
reinvestment made by shareholders. Organisations that earn or gain more
returns than costs incurred are known as growth firms. The payout of such
firms is zero.
•If the rate of return is equal to the cost of capital (r = k), then the
organisation’s dividend will not impact its value. In such conditions, the
organisation has to decide how much they will keep and how much they will
distribute among shareholders. The payout ratio changes with different
circumstances in the case. It would either be zero or 100%.
•If r < k, then the organisation should have distributed all its return or
earnings among the shareholders through dividends. It will give rise to more
Advantages of Walter’s Model
1. The formula is simple to understand and easy to compute.

2. It can envisage different possible market prices in different situations

and considers internal rate of return, market capitalisation rate and
dividend payout ratio in the determination of market value of shares.

Limitations of Walter’s Model

1.The formula does not consider all the factors affecting dividend policy
and share prices. Moreover, determination of market capitalisation rate
is difficult.

2. Further, the formula ignores such factors as taxation, various legal

and contractual obligations, management policy and attitude towards
 GORDON MODEL(BIRD-IN-THE-HAND THEORY)

Supports the relevance of dividends in determining firm value.

•Emphasizes that current dividends are preferred over future gains.
•Myron Gordon’s model explicitly relates the market value of the company to its
dividend policy. The determinants of the market value of the share are the perpetual
stream of future dividends to be paid, the cost of capital and the expected annual
growth rate of the company.
•Based on the relationship between the dividend payout ratio, cost of capital (k),
and return on investment (r).
•Relationship between r and k Increase in Dividend Payout
• r>k Price per share decreases
• r<k Price per share increases
•r=k No change in the price per share
•Formula: P = {EPS * (1-b)} / (k-g)
Assumptions of Gordon’s Model
•No debt: Firm is financed entirely by equity.
•No external financing: Investments funded solely through
retained earnings.
•Constant IRR & Cost of Capital: Assumes r and k remain
unchanged.
•Perpetual earnings: The firm has indefinite earnings.
•Corporate taxes ignored.

Implications:
•Growth firms (r > k): Reinvestment is better; payout ratio =
0%.
•Normal firms (r = k): No impact on share price.
Criticism firms (r < k): High dividends preferred; payout ratio
•Declining
=•Unrealistic
100%. assumptions (constant r, k and no external
financing).
•Ignores changing business risks.
•Rigid dividend policy may not suit all firms.
Example
•Given: EPS = ₹15, b = 70%, k = 12%, g = 10%
•Market price (P) = {15 * (1-0.7)} / (0.12 - 0.10) =
₹225
 IMPLICATIONS OF 3 THEORIES
FOR MANAGERS

Theory Implication
Irrelevance Any payout OK
Bird in the Hand Set high payout
Tax preference Set low payout

But which, if any, is

correct???
 WHICH THEORY IS MOST CORRECT?
• Empirical testing has not been able to determine which theory, if any, is correct. Thus, managers use judgment when
setting policy.
Which Model is the Best?
• If we assume perfect markets, MM Hypothesis holds true—dividends do not impact firm value.
• In reality, investors prefer stable and predictable dividends, making Gordon’s Model more practical.
• Walter’s Model is useful when firms have high-return investment opportunities, while Residual Theory is best for firms
prioritizing reinvestment.
👉 Best Approach: A Balanced Dividend Policy
An optimal dividend policy should be a mix of stability and flexibility. A good firm should:
1.Prioritize Profitable Investments: Follow Residual Theory—reinvest profits if r > k.
2.Ensure Dividend Stability: Investors prefer stable dividends, supporting Gordon’s Model.
3.Maintain Flexibility: Avoid rigid payout ratios; consider Walter’s Model based on firm performnc
4.Consider Investor Preferences: Some investors seek growth (prefer reinvestment), others need income (prefer
dividends).
5.Balance Growth & Shareholder Returns: A firm should maintain an optimal payout ratio that supports both growth and
investor expectations.
 SETTING DIVIDEND POLICY

• Forecast capital needs over a planning horizon, often 5 years.

• Set a target capital structure.
• Estimate annual equity needs.
• Set target payout based on the residual model.
• Generally, some dividend growth rate emerges. Maintain target
growth rate if possible, varying capital structure somewhat if
necessary.
 STOCK SPLIT BONUS ISSUE

Issuing additional
Splitting existing
shares to existing
shares into multiple
Definition shareholders
lower-priced shares
(e.g.1:2 bonus
(e.g., 2-for-1 split).
issue).
No change (Total No change (Total
Effect on Market
shares × New MPS shares × New MPS
Capitalization
remains the same). remains the same).

Decreases Decreases
proportionally (e.g., proportionally (e.g.,
Effect on MPS if ₹1,000 before a 2- if ₹1,000 before a
for-1 split, then ₹500 1:1 bonus, then ₹500
after).
Increases after).
Increases
Effect on No. of proportionally (e.g., proportionally (e.g.,
Shares 2x for a 2-for-1 20% more shares for
split). a 20% bonus issue).
Decreases Decreases
proportionally as proportionally as
Effect on EPS shares increase, but shares increase, but
total net profit total net profit
 Retained earnings
No impact on
Effect on decrease as they
reserves or
Reserves are converted into
retained earnings.
share capital.

Generally positive;
Positive; seen as a
Investor makes shares
signal of strong
Perception more accessible to
future growth.
retail investors.
Decreases (e.g., if
face value was
Effect on Face
₹10, it becomes ₹5 Remains the same.
Value
after a 2-for-1
split).

To make shares To reward

more affordable shareholders and
Purpose
and increase reinvest profits in
liquidity. the business.
 WHEN SHOULD A FIRM CONSIDER SPLITTING
ITS STOCK?

• There’s a widespread belief that the optimal price range for

stocks is $20 to $80.
• Stock splits can be used to keep the price in the optimal range.
• Stock splits generally occur when management is confident, so
are interpreted as positive signals.
• To improve the liquidity for the stock in the market by increasing
the outstanding number of shares and make the stocks
affordable to attract bigger range of . Investors.
 DETERMINANTS OF DIVIDEND
POLICY

 Dividend payout Ratio

 Stability of Dividends
 Legal, contractual and internal constraints and
restrictions
 Owner’s considerations
 Clientele effect
 Capital market considerations
 Inflation
 WHAT’S THE “CLIENTELE EFFECT”?

• Different groups of investors, or clienteles, prefer different

dividend policies.
• The dividend clientele effect states that high-tax bracket investors
(like wealthy/young individuals) prefer low dividend payouts and
low tax bracket investors (like retired individuals,
pensioners ,endowment funds etc) prefer high dividend payouts.
So different groups desire different levels of dividends.
• Taxes & brokerage costs hurt investors who have to switch
companies.
• Clientele effects impede changing dividend policy.
 COMPANIES ACT 2013 REQUIREMENTS

a) Declaration of Dividend (Section 123) : A company can declare dividends only out of:
• Current year’s profits after providing for depreciation.
• Past retained profits (reserves) if current profits are insufficient.
• Money provided by the government for dividend payments (in case of government
companies).
• Dividends must be approved by the Board of Directors and, in case of final dividend, by
shareholders at the AGM.

b) Interim Dividend:
• The Board of Directors can declare an interim dividend before the end of the financial year.
• It can be paid out of profits of the current financial year only (not reserves).

c) Transfer to Reserves (Mandatory Reserve Requirements)

• If a company declares a dividend, it may voluntarily transfer a portion of profits to reserves.
• Earlier, the law required transferring a certain percentage of profits before declaring dividends,
but this is now at the company’s discretion.
d) Payment of Dividend (Timeframe & Mode): Dividends
must be paid within 30 days from the date of declaration.
Payment can be made via: Cheque ,Electronic transfer, Any other
approved mode

e) Unpaid Dividend & Investor Protection Fund (Section

124) : Any unpaid dividend must be transferred to the Unpaid
Dividend Account within 7 days from the expiry of the 30-day
period.
•If a dividend remains unclaimed for 7 years, it must be
transferred to the Investor Education and Protection Fund (IEPF).

f) Restrictions on Dividend Payment (Section 125 & Other

Provisions)
A company cannot declare dividends if:
•It has defaulted in repaying deposits, interest, loans, or statutory
dues (e.g., provident fund, gratuity, bonus).
•The company has inadequate or no profits, except in certain
cases where past reserves can be used.
 SEBI GUIDELINES
For listed companies, the Securities and Exchange Board of India (SEBI)
provides additional regulations under the Listing Obligations and
Disclosure Requirements (LODR) Regulations, 2015:
a) Disclosure Requirements
• Companies must disclose their dividend distribution policy if they are
among the top 1,000 listed companies (based on market
capitalization).
• The policy should include factors like retained earnings, growth
plans, and investor expectations.
b) Timely Payment & Intimation
• Dividends must be credited to shareholders within 30 days of
declaration.
• Companies must inform stock exchanges within 30 minutes of Board
approval of dividends.

https://www.ril.com/sites/default/files/2023-01/Dividend-Distributi
on-Policy.pdf
c) Record Date & Book Closure
•Companies must fix a record date (the cutoff date for
shareholders eligible to receive dividends).
•A minimum 7-day advance notice must be given before the
record date.

d) Restrictions on Dividend Payment

SEBI restricts dividend payments if:
•The company has defaulted on loan repayments or
statutory dues.
•The company has not complied with SEBI’s corporate
governance norms.