Financial Management Notes: Dividend Decision

Unit – IV: Dividend Decisions
Meaning of Dividend and Dividend Policy
Meaning of Dividend: A dividend is that portion of profits and surplus funds of a company which has actually set aside by a valid act of the company for distribution among its shareholders.
According to ICAI, “Dividend is the distribution to the shareholders of a company from the reserves and profits.”
In the words of S.M. Shah, “Dividend is a part of divisible profits of a business company which is distributed to the shareholders.”
Dividend may be divided into following categories:
1.       Cash Dividend.
2.       Stock Dividend or Bonus Dividend.
3.       Bond Dividend.
4.       Property Dividend.
5.       Composite Dividend.
6.       Interim Dividend.
7.       Special or Extra Dividend.
8.       Optional Dividend.
Some of these are explained below:
CASH DIVIDEND: A Cash dividend is the most common form of the dividend. The shareholders are paid in cash per share. The board of directors announces the dividend payment on the date of declaration. The dividends are assigned to the shareholders on the date of record. The dividends are issued on the date of payment. But for distributing cash dividend, the company needs to have positive retained earnings and enough cash for the payment of dividends.
BONUS SHARE: Bonus share is also called as the stock dividend. Bonus shares are issued by the company when they have low operating cash, but still want to keep the investors happy. Each equity shareholder receives a certain number of additional shares depending on the number of shares originally owned by the shareholder. For example, if a person possesses 10 shares of Company A, and the company declares bonus share issue of 1 for every 2 shares, the person will get 5 additional shares in his account. From company’s angle, the no. of shares and issued capital in the company will increase by 50% (1/2 shares). The market price, EPS, DPS etc will be adjusted accordingly.
INTERIM DIVIDEND: This dividend is issued between two accounting year on the basis of expected profit. This dividend is declared before the preparation of final accounts.
PROPERTY DIVIDEND: The company makes the payment in the form of assets in the property dividend. The asset could be any of this equipment, inventory, vehicle or any other asset. The value of the asset has to be restated at the fair value while issuing a property dividend.
SCRIP DIVIDEND: Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used when the company does not have sufficient funds for the issuance of dividends.
LIQUIDATING DIVIDEND: When the company returns the original capital contributed by the equity shareholders as a dividend, it is termed as liquidating dividend. It is often seen as a sign of closing down the company.
Meaning of Dividend Policy: A policy which determines the amount of earnings to be distributed to the shareholders and the amount to be retained in the company as retained earnings, is called dividend policy. In short, dividend policy determines the division of earnings between payment to shareholders and retained earnings.
Types of Dividend Policy
Every company which is listed and is making profits has to take the decision regarding the distribution of profits to its shareholders as they are the ones who have invested their money into the company. This distribution of profits by the company to its shareholders is called dividend in finance parlance, every company has different objectives and methods and dividend is no different and that is the reason why different companies follow different dividend policies, let’s look at various types of dividend policies:
1) Regular dividend policy: Under this type of dividend policy a company has the policy of paying dividends to its shareholders every year. When the company makes abnormal profits then the company will not pay that extra profits to its shareholders completely rather it will distribute lower profit in the form of the dividend to the shareholders and keep the excess profits with it and suppose a company makes loss then also it will pay dividend to its shareholders under regular dividend policy. This type of dividend policy is suitable for those companies which have constant cash flows and have stable earnings. Investors like retired person and conservative investors who prefer safe investment and constant income will invest in constant dividend paying companies.
2) Stable Dividend Policy: Stability of dividends means regularity in payment of dividends. It refers to the consistency in stream of dividends. In short, we can say that a stable dividend policy is a long term policy which is not affected by the variations in the earnings during different periods. The stability of dividends can take any one of the three forms:
a)      Constant D/P ratio.
b)      Constant dividends per share.
c)       Constant dividend per share plus extra dividends.
Merits of Stable Dividend Policy: Following are some of the advantages of a stable dividend policy:
a)      This policy contributes to stablise market value of company’s equity shares at a high level.
b)      This policy helps the company is mobilizing additional funds in the form of additional equity shares.
c)       Regular earnings in the form of dividend satisfy investors.
d)      This policy encourages shareholders to hold company’s share for longer time and simultaneously other investors are also attracted for the purchase of shares.
e)      This policy is helpful for expansion and growth prospects of a company.
f)       This policy encourages the institutional investors because they like to invest in those companies which make uninterrupted payment of dividends.
Demerits of Stable Dividend Policy: Following are some of the disadvantages of a stable dividend policy:
a)      Sometime despite of large earnings, management decides not to declare dividends.
b)      In this policy, instead of paying dividend in cash, bonus share are issued to the shareholders.
c)       This policy is used to capitalise reinvested earnings of the firm.
3) Irregular dividend policy: Under this type of policy there is no mandate to give dividends to shareholders of the company and top management gives it according to its own free will, so suppose company has some abnormal profits then management may decide to pass it fully to its shareholders by giving interim dividend or management may decide to use it for future business expansion. Companies which have irregular earnings, lack of liquidity and are afraid of committing itself for paying regular dividends adopt irregular dividend policy.
4) No dividend policy: Under this policy company pays no dividend to its shareholders, the reason for following this type of policy is that company retains the profit and invest in the growth of the business. Companies which have ample growth opportunities follow this type of policy and shareholders who are looking for growth invest in these types of companies because there is plenty of scope of capital appreciation in these stocks and if the company is successful then capital appreciation will outdo regular dividend income as far as shareholders are concerned.
Factors Influencing Dividend Decision
There are various factors which affect dividend decision. These are enumerated below with brief explanation.
a)      Legal position: Section 205 of the Companies Act, 1956 which lays down the sources from which dividend can be paid, provides for payment of dividend (i) out of past profits and (ii) out of moneys provided by the Central/State Government, apart from current profits. Thus, by law itself, a company may be allowed to declare a dividend even in a year when the profits are inadequate or when there is absence of profit.
b)      Magnitude and Trend in EPS: EPS is the basis for dividend. The size of the EPS and the trend in EPS in recent years set how much can be paid as dividend a high and steadily increasing EPS enables a high and steadily increasing DPS. When EPS fluctuates a different dividend policy has to be adopted.
c)       Taxability: According to Section 205(3) of the Companies Act, 1956 'no dividend shall be payable except in cash'. However, the Income-Tax Act defines the term dividend so as to include any distribution of property or rights having monetary value. Therefore liberal dividend policy becomes unattractive from the point of view of the shareholders/investors in high income brackets. Thus a company which considers the taxability of its shareholders, may not declare liberal dividend though there may be huge profit, but may alternatively go for issuing bonus shares later.
d)      Liquidity and Working Capital Position: Apparently, distribution of dividend results in outflow of cash and as such a reduction in working capital position. Even in a year when a company has earned adequate profit to warrant a dividend declaration, it may confront with a week liquidity position. Under the circumstance, while one company may prefer not to pay dividend since the payment may impair liquidity, another company following a stable dividend policy, may wish to declare dividends even by resorting to borrowings for dividend payment in cash.
e)      Impact on share price: The impact of dividends on market price of shares, though cannot be precisely measured, still one could consider the influence of dividend on the market price of shares. The dividend policy pursued by a company naturally depends on how far the management is concerned about the market price of shares. Generally, an increase in dividend payout results in a hike in the market price of shares. This is significant as it has a bearing on new issues.
f)       Control consideration: Where the directors wish to retain control, they may desire to finance growth programmes by retained earnings, since issue of fresh equity shares for financing growth plan may lead to dilution of control of the dominating group. So, low dividend payout is favoured by Board.
g)      Type of Shareholders: When the shareholders of the company prefer current dividend rather man capital gain a high payment is desirable. This happens so, when the shareholders are in low tax brackets, they are less moneyed and require periodical income or they have better investment avenues than the company. Retired persons, economically weaker sections and similarly placed investors prefer current income i.e. dividend. If, on the other hand, majority of the shareholders are moneyed people, and want capital gain, then low payout ratio is desirable. This is known as clientele effect on dividend decision.
h)      Industry Norms: The industry norms have to be adhered to the extent possible. It most firms in me industry adopt a high payout policy, perhaps others also have to adopt such a policy.
i)        Age of the company: Newly formed companies adopt a conservative dividend policy so that they can get stabilized and think of growth and expansion.
j)        Investment opportunities for the company: If the company has better investment opportunities, and it is difficult to raise fresh capital quickly and at cheap costs, it is better to adopt a conservative dividend policy. By better investment opportunities we mean those with higher 'r' relative to the 'k'. So, if r>k, low payout is good. And vice versa.
k)      Restrictive covenants imposed by debt financiers: Debt financiers, especially term lending financial institutions, may impose restrictive conditions on the rate, timing and form of dividends declared. So, that consideration is also significant.
l)        Floatation cost, cost of fresh equity and access capital market: When floatation costs and cost of fresh equity are high and capital market conditions are not congenial for a fresh issue, a low payout ratio is adopted.
m)    Financial signaling: Dividends are the best medium to tell shareholder of better days ahead of the company. When a company enhances the target dividend rate, it overwhelmingly signals the shareholders that their company is on stable growth path. Share prices immediately react positively.
Modigliani and Miller approach (M & M Hypothesis)
The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.
Like several financial theories, M&M hypothesis is based on the argument of efficient capital markets. In addition, there are two options:
(a) It retains earnings and finances its new investment plans with such retained earnings;
(b) It distributes dividends, and finances its new investment plans by issuing new shares.
The intuitive background of the M&M approach is extremely simple, and in fact, almost self explanatory. It is based on the following assumptions:
a)      The capital markets are perfect and the investors behave rationally.
b)      All information is freely available to all the investors.
c)       There is no transaction cost.
d)      Securities are divisible and can be split into any fraction. No investor can affect the market price.
e)      There are no taxes and no flotation cost.
f)       The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get the same benefit from dividend as from capital gain through retained earnings. So, the division of earnings into dividend and retained earnings does not influence shareholders' perceptions. So whether dividend is declared or not, and whether high or low payout ratio is follows, it makes no difference on the value of the share. In order to satisfy their model, MM has started with the following valuation model.
P0= 1* (D1+P1)/ (1+ke)
P0 = Present market price of the share
Ke = Cost of equity share capital
D1 = Expected dividend at the end of year 1
P1 = Expected market price of the share at the end of year 1
With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:
a)      Payment of dividend by the firm
b)      Rising of fresh capital.
With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralized by the decrease in terminal value of the share.
Criticisms on MM Dividend theory: MM theory is criticized on the invalidity of most of its assumptions. Some of the criticisms are presented below:
a)      First, perfect capital market is not a reality.
b)      Second, transaction and floatation costs do exist.
c)       Third, Dividend has a signaling effect. Dividend decision signals financial standing of the business, earnings position of the business, and so on. All these are taken as uncertainty reducers and that these influence share value. So, the stand of MM is not tenable.
d)      Fourth, MM assumed that additional shares are issued at the prevailing market price. It is not so. Fresh issues - whether rights or otherwise, are made at prices below the ruling market price.
e)      Fifth, taxation of dividend income is not the same as that of capital gain. Dividend income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20% tax in the case of individual assesses. So, investor preferences between dividend and capital gain differ.
f)       Sixth, investment decisions are not always rational. Some, sub-marginal projects may be taken up by firms if internally generated funds are available in plenty. This would deflate ROI sooner than later reducing share price.
g)      Seventh, investment decisions are tied up with financing decisions. Availability of funds and external constrains might affect investment decisions and rationing of capital, then becomes a relevant issue as it affects the availability of funds.
Walter’s Dividend theory
Professor James E. Walter argues 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.
Valuation Formula and its Denotations: Walter’s formula to calculate the market price per share (P) is:
P = D/k + {r*(E-D)/k}/k, where
P = market price per share
D = dividend per share
E = earnings per share
r = internal rate of return of the firm
k = cost of capital of the firm
Explanation: The mathematical equation indicates that the market price of the company’s share is the total of the present values of:
a)      An infinite flow of dividends, and
b)      An infinite flow of gains on investments from retained earnings.
The formula can be used to calculate the price of the share if the values of other variables are available.
Walter’s model is based on the following assumptions:
a)      The firm finances all investment through retained earnings; that is debt or new equity is not issued;
b)      The firm’s internal rate of return (r), and its cost of capital (k) are constant;
c)       All earnings are either distributed as dividend or reinvested internally immediately.
d)      Beginning earnings and dividends never change. The values of the earnings per share (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.
e)      The firm has a very long or infinite life.
Criticism of Walter’s theory:
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 optimize 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.
Gordon’s Dividend Theory
The Gordon’s Model, given by Myron Gordon, also supports the doctrine that dividends are relevant to the share prices of a firm. Here the Dividend Capitalization Model is used to study the effects of dividend policy on a stock price of the firm. Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return and a discount on the uncertain returns. The investors prefer current dividends to avoid risk; here the risk is the possibility of not getting the returns from the investments.
But in case, the company retains the earnings; then the investors can expect a dividend in future. But the future dividends are uncertain with respect to the amount as well as the time, i.e. how much and when the dividends will be received. Thus, an investor would discount the future dividends, i.e. puts less importance on it as compared to the current dividends.
According to the Gordon’s Model, the market value of the share is equal to the present value of future dividends. It is represented as:
P = [E (1-b)] / Ke-br
Where, P = price of a share
E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate
Br = growth rate
Assumptions of Gordon’s Model:
1) The firm is an all-equity firm; only the retained earnings are used to finance the investments, no external source of financing is used.
2) The rate of return (r) and cost of capital (K) are constant.
3) The life of a firm is indefinite.
4) Retention ratio once decided remains constant.
5) Growth rate is constant (g = br)
6) Cost of Capital is greater than br
Criticism of Gordon’s Model
1) It is assumed that firm’s investment opportunities are financed only through the retained earnings and no external financing viz. Debt or equity is raised. Thus, the investment policy or the dividend policy or both can be sub-optimal.
2) The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of returns is constant, but, however, it decreases with more and more investments.
3) It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in the real life situations, as it ignores the business risk, which has a direct impact on the firm’s value.
Thus, Gordon model posits that the dividend plays an important role in determining the share price of the firm.
Retained Earnings or Ploughing Back of Profit
Retained earnings are internal sources of finance for any company. Actually is not a method of raising finance, but it is called as accumulation of profits by a company for its expansion and diversification activities. Retained earnings are called under different names such as self finance; inter finance, and plugging back of profits.  As prescribed by the central government, a part (not exceeding 10%) of the net profits after tax of a financial year have to be compulsorily transferred to reserve by a company before declaring dividends for the year.
Under the retained earnings sources of finance, a reasonable part of the total profits is transferred to various reserves such as general reserve, replacement fund, reserve for repairs and renewals, reserve funds and secrete reserves, etc.
Retained earnings or profits are ploughed back for the following purposes.
1)      Purchasing new assets required for betterment, development and expansion of the company.
2)      Replacing the old assets which have become obsolete.
3)      Meeting the working capital needs of the company.
4)      Repayment of the old debts of the company.
Advantages of Retained Earnings
Retained earnings consist of the following important advantages:
1. Useful for expansion and diversification: Retained earnings are most useful to expansion and diversification of the business activities.
2. Economical sources of finance: Retained earnings are one of the least costly sources of finance since it does not involve any floatation cost as in the case of raising of funds by issuing different types of securities.
3. No fixed obligation: If the companies use equity finance they have to pay dividend and if the companies use debt finance, they have to pay interest. But if the company uses retained earnings as sources of finance, they need not pay any fixed obligation regarding the payment of dividend or interest.
4. Flexible sources: Retained earnings allow the financial structure to remain completely flexible. The company need not raise loans for further requirements, if it has retained earnings.
5. Increase the share value: When the company uses the retained earnings as the sources of finance for their financial requirements, the cost of capital is very cheaper than the other sources of finance; hence the value of the share will increase.
6. Avoid excessive tax: Retained earnings provide opportunities for evasion of excessive tax in a company when it has small number of shareholders.
7. Increase earning capacity: Retained earnings consist of least cost of capital and also it is most suitable to those companies which go for diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:
1. Misuses: The management by manipulating the value of the shares in the stock market can misuse the retained earnings.
2. Leads to monopolies: Excessive use of retained earnings leads to monopolistic attitude of the company.
3. Over capitalization: Retained earnings lead to over capitalization, because if the company uses more and more retained earnings, it leads to insufficient source of finance.
4. Tax evasion: Retained earnings lead to tax evasion. Since, the company reduces tax burden through the retained earnings.
5. Dissatisfaction: If the company uses retained earnings as sources of finance, the shareholder can’t get more dividends. So, the shareholder does not like to use the retained earnings as source of finance in all situations.
Calculation of Cost of Retained Earnings
Generally, retained earnings are considered as cost free source of financing. It is because neither dividend nor interest is payable on retained profit. However, this statement is not true. Shareholders of the company that retains more profit expect more income in future than the shareholders of the company that pay more dividends and retains less profit. Therefore, there is an opportunity cost of retained earnings. In other words, retained earnings is not a cost free source of financing. The cost of retained earning must be at least equal to shareholders rate of return on re-investment of dividend paid by the company.
Determination of Cost of Retained Earning
In the absence of any information relating to addition of cost of re-investment and extra burden of personal tax, the cost of retained earnings is considered to be equal to the cost of equity. However, the cost of retained earnings differs from the cost of equity when there is flotation cost to be paid by the shareholders on re-investment and personal tax rate of shareholders exists.
i) Cost of retained earnings when there is no flotation cost and personal tax rate applicable for shareholders:
Cost of retained earnings (kr) = Cost of equity (ke) = (D1/NP) +g where,
D1= expected dividend per share
NP= current selling price or net proceed
ii) Cost of retained earnings when there is flotation cost and personal tax rate applicable for shareholders:
Cost of retained earnings (kr) = Cost of equity (ke) x 1-fp) (1-tp)
Fp = flotation cost on re-investment (in fraction) by shareholders
Tp = Shareholders' personal tax rate.
Determinants or Factors of Ploughing Back of Profits or Retained Earnings
(a)    Total Earnings of the Enterprise: The question of saving can arise only when there are sufficient profits. So larger the earnings larger the savings, it is a common principle of financial management.
(b)   Taxation Policy of the Government: The report submitted by Taxation Enquiry Commission has brought into light that taxation policy of the Government tells upon it the taxes are levied at high rates. Hence, it is also an important determinant of corporate savings.
(c)    Dividend Policy: It is policy adapted by the top management (board of directors) in regards to distribution of profits. A conservative dividend policy is essential for having good accumulation of corporate savings. But, dividend policy is highly influenced by the income expectation of shareholders and by general environment prevailing in the country.
(d)   Government Attitudes and Control: Govt. is not only a silent spectator but a regulatory body of economic system of the country. Its policies, control order and regulatory instructions-all compel the organizations to work in that very direction for example compulsory Deposit Scheme which had been in force.
(e)   Other Factors : Other factors affecting the retained earnings are:
(a)    Tradition of industry.
(b)   General economic and social environment prevailing in the country.
(c)    Managerial attitudes and philosophy, etc.
Dividend Payout Ratio and Optimal Dividend Payout Ratio
The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders. Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. The dividend payout formula is calculated by dividing total dividend by the net income of the company i.e.
Dividend Payout Ratio = Total Dividend/Net income
Optimal Dividend Payout Ratio: Dividend payout ratio maximizes the firm’s value. A payout ratio which maximizes the firm’s value is called optimal dividend payout ratio. A firm achieves this dividend payout-ratio at that point where it minimises the total cost of financing.  The minimization of sum of total cost of financing produces a unique dividend payout ratio for the firm.

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