Dividend Policy

Meaning Of Dividend (2 Marks):

Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders. According to the institute of chartered accountant of india, dividend is defined as
“a distribution to shareholders out of profits or reserves available for this purpose”.

Types of dividend/forms of dividend (4 marks) (all these may be asked for 2 marks also)

(a) Cash Dividend: Cash Dividend is a usual method of paying dividends. Payment of dividend
is cash results in the reduction out flow of funds and reduces the net worth of the company.
The shareholders get an opportunity to invest the cash in any manner, they desire. Hence, the
ordinary shareholders prefer to receive dividends in cash. In case of company paying cash
dividend, the firm must have adequate liquid resources, so that its liquidity position is not
adversely affected on account of cash dividend.

*** (B) Scrip (Or) Bond Dividend: Scrip Dividend promises to pay the shareholders at a
future specific date. In case a company does not have sufficient funds to pay dividends in
cash, it may issue notes or bonds for amounts due to the shareholders. The objective of scrip
dividends is to postpone the immediate payment of cash. It bears interest and is accepted as
collateral security.

(c) Property Dividend: Property Dividends are paid in the form of some assets other than
cash. They are distributed under exceptional circumstances and are not popular in India.

(d) Stock Dividend: Stock Dividend means the issue of bonus shares to the existing
shareholders. If a company does not have liquid resources, it is better to declare stock
dividends. It amounts to capitalization of earnings and distribution of profits among the
existing shareholders without affecting the cash position of the firm.
***Factors Determining Dividend Policy (4/12Marks):

Dividend policy is the policy which concerns quantum of profits to be distributed by way of
dividend.

Dividend policy of a company sets the guidelines to be followed while deciding the amount of
dividend to be paid out to the shareholders. The company needs to adhere to the dividend
policy while deciding the proportion of earnings to be distributed and the frequency of the
distribution.

A company needs to analyze certain factors before framing their dividend policy. The
following are the various factors/determinants that impact the dividend policy of a
company:

1. Profitable position of the firm:: Dividend Decision depends on the profitable position of
the business concern. When the firm earns more profit, they can distribute more dividends
to the shareholders.

2. Uncertainty of future income: Future Income is a very important factor which affects the
dividend policy. When the shareholder needs regular income, the firm should maintain regular
dividend policy.

3. Contractual constraints: Often, the firm’s ability to pay cash dividends is constrained by
restrictive provisions in a loan agreement. Generally, these constraints prohibit the payment
of cash dividends until a certain level of earnings have been achieved, or they may limit
dividends to a certain amount or a percentage of earnings. Constraints on dividends help to
protect creditors from losses due to the firm’s insolvency.

4. Internal constraints: The Firm’s ability to pay cash dividends is generally constrained by
the amount of excess cash available rather than the level of retained earnings against which
to charge them. Although the firm may have high earnings, its ability to pay dividends may be
constrained by a low level of liquid assets. (Cash and marketable securities)

5. Growth Prospects: Firm’s Financial Requirements are directly related to the anticipated
degree of asset expansion. If the firm is in a growth stage, it may need all its funds to finance
capital expenditures. Firms exhibiting little or no growth may never need replace or renew
assets. A growth firm is likely to have to depend heavily on internal financing through
retained earnings instead of distributing current income as dividends

6. Owner considerations in establishing a dividend policy, The Firm’s Primary Concern

normally would be to maximize shareholder’s wealth. One such consideration is then tax
status of a firm’s owners. Suppose that if a firm has a large percentage of wealthy
shareholders who are in a high tax bracket, it may decide to pay out a lower percentage of
its earnings to allow the owners to delay the payments of taxes until they sell the stock.
Lower-income shareholders, however who need dividend income will prefer a higher payout
of earnings.

7. Market considerations: The Risk-Return concept also applies to the firm’s dividend policy.
A firm where the dividends fluctuate from period to period will be viewed as risky, and
investors will require a high rate of return, which will increase the firm’s cost of capital.
So, the firm’s dividend policy also depends on the market’s probable response to certain
types of policies. Shareholders are believed to value a fixed or increasing level of dividends as
opposed to a fluctuating pattern of dividends.

8. Legal constrains: The Companies Act 1956 has put several restrictions regarding
payments and declaration of dividends. Similarly, income tax act, 1961 also lays down
certain restrictions on payment of dividends.

9. Liquidity position: Liquidity Position of the firms leads to easy payments of dividend. If the
firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay
stock dividend.

10. Sources of finance: if the firm has finance sources, it will be easy to mobilize large
finance. The firm shall not go for retained earnings.

11. Growth rate of the firm: High Growth Rate implies that the firm can distribute more
dividends to its shareholders.

12. Tax policy: Tax Policy of the Government also affects the dividend policy of the firm.
When the government gives tax incentives, the company pays more dividends.
13. Capital market conditions: Due to the capital market conditions, dividend policy may be
affected. If the capital market is prefect, it leads to improve the higher dividend.

Conclusion: Payment of dividend involves some legal as well as financial considerations. It is

difficult to determine a general dividend policy which can be followed by different firms at
different times because dividend decision has to be taken considering the special circumstances
of an individual case.

***Types Of Dividend Policies In Practice (12 marks):

The dividend policy is a financial decision that refers to the proportion of the firm’s
earnings to be paid out to the shareholders.

On the basis of dividend declaration by the firm, the dividend policy may be classified under the
following types:

• Regular Dividend Policy

• Stable Dividend Policy

• Irregular Dividend Policy

• No Dividend Policy.

The various types of dividend policies are discussed as follows:

(a) Regular Dividend Policy: Payment of Dividend at usual rate is termed as regular
dividend. The investors such as retired persons, widows, and other economically weaker
persons prefer to get regular dividends. A regular dividend offer following advantages.

 It establishes profitable record of company.

 It creates confidence among shareholder.
 It stabilises market value of shares
 It aids in long term financing and renders financing easier.
 The ordinary shareholders view dividends as a source of founds to meet their day-to-day
living expenses.
  Regular dividend can be maintained only by companies of long standing and stable
earnings.

(b) Stable Dividend Policy: The term ‘Stability of Dividend’ means consistency or lack of
variability in stream of dividend payments. A stable dividend policy may be established in
any of following three forms.

 constant dividend per share:

 constant payout ratio:
 stable rupee dividend plus extra dividend:.

Three distinct forms of such stability are explained below.

1. Constant dividend per share: A number of companies follow the policy of paying a fixed
amount per share as dividend every year, irrespective of the fluctuations in the earnings.
This policy does not imply that the dividend per share will never be increased. When the
company reaches new levels of earnings and expects to maintain it, the annual dividend per
share may be increased. The dividend policy of paying a constant amount of dividend per
year treats common shareholders somewhat like preference shareholders without giving
any consideration to investment opportunities within the firm and the opportunities
available to shareholders.

2. Constant Percentage of Net earnings: The ratio of dividend to earnings is known as

payout ratio. Some companies follow a policy of constant payout ratio, i.e., paying a fixed
percentage of net earnings every year. With this policy the amount of dividend will fluctuate in
direct proportion to earnings. If a company adopts a 40 per cent payout ratio, then 40 percent
of every rupee of net earnings will be paid out. Tthis type of a policy may be supported by
management because it is related to the company’s ability to pay dividends.

3. Small constant dividend per share plus extra dividend: Under this policy, a small amount
of dividend is fixed to reduce the possibility of ever missing a dividend payment and extra
dividend is paid in periods of prosperity. This type of a policy enables a company to pay
constant amount of dividend regularly without a default and allows a great deal of
flexibility for supplementing the income of shareholders only when the company’s earnings
are higher than the usual.

(c) Irregular Dividend Policy: Some Companies follow irregular dividend payments on
account of following:

 Uncertainty of business.
 Unsuccessful business operations
 Lack of liquid resources.
 Fear of adverse effects of regular dividend on financial standing of company.

(d) No Dividend Policy: A company may follow a policy of paying no dividends presently
because of its unfavourable working capital position or on account of requirements of
funds for future expansion and growth.

Stable Dividend Policy:

Stability or regularity of dividends is considered as a desirable policy by the management of

most companies.

The Term ‘Stability of Dividend’ means consistency or lack of variability in stream of

dividend payments.

A stable dividend policy may be established in any of following three forms.

(i) Constant dividend per share:

(ii) Constant payout ratio:

(iii) Stable rupee dividend plus extra dividend:.

***advantages/significance of stable dividend policy :(5 marks)

From the point of view of shareholders as well as company the stability of dividends has various
advantages.

1. Resolution of investor’s uncertainty:: When a company follows a policy of stable dividends,

it will not change the amount of dividend if there are temporary changes in the earnings, thus,
when the earnings of a company fail and it continues to pay same amount of dividend as in the
past, it conveys to investors that the future of the company is bright than suggested by drop in
earnings

2. Investor’s desire for current income: The investors who desire (old and retired persons,
women, children etc.) To receive a regular dividend income, will prefer a company with stable
dividends to one with fluctuating dividends.

3. Institutional investors’ requirements: The financial institutions like ifc, idbi, lic and uti
generally invest in the shares of those companies which have a record of paying regular
dividends.

4. Raising additional finances: A stable dividend policy is also advantageous to the company in
its efforts to raise external finances. Stable and regular dividend policy tends to make the shares
of a company and investment rather than a speculation.

Conclusion:

Form the above, it can be said that shareholders also generally favour this policy and value stable
dividends higher than the fluctuating ones. All other things being the same, stable dividends have
a positive impact on the market price of the share. In spite of many advantages, the stable
dividend policy suffers from certain limitations

Dangers of stable dividend policy

In spite of many advantages, the stable dividend policy suffers from certain limitations.

 Once a stable dividend policy is followed by a company, it is not easier to change it.
 If stable dividends are not paid to shareholders on any account including insufficient
profits, the financial standing of company in minds of investors is damaged and they may
like to dispose of their holdings. It adversely affects the market price of shares of the
company.
 And if a company pays stable dividends in spite of its incapacity, it will be suicidal in
long run.
***bonus shares/stock dividend (4/12 marks)

Bonus shares are the shares issued by a company free of costs by capitalisation of its profits
and reserves. The issue of bonus shares results in increase in number of shares and hence
increases the paid up capital of company without involving any monetary transaction. Such
shares are issued to all existing equity shareholders in proportion of their holding of share
capital of company.

***advantages of issuing bonus shares:

A. From the company’s view point:

(1) Economical: It is an inexpensive mode of raising capital by which cash resources of

company can be used for some other expansion project.

(2) Wider Marketability: When bonus shares are issued, market price of share is automatically
reduced which increases its wider marketability.

(3) Increase In Credit Worthiness: Issuing bonus shares mean capitalisation of profits and
capitalisation of profits always increases the credit worthiness of the company to borrow funds.

(4) More Realistic Balance Sheet: Balance Sheet of the company will reveal more realistic
picture after the issue of bonus shares.

(5) More Capital Availability: Issue of Bonus shares increases the goodwill of company in
capital market and builds confidence among investors and helps raising additional funds in
future.

(6) Unaltered Liquidity Position: liquidity cash position of the company will remain unaltered
with the issue of bonus shares because issue of bonus shares does not result into inflow or
outflow of cash.
(7) Since, Bonus Shares Is Capital Receipt, it is not taxable in hands of issuing company as
well as shareholders.

(8) It makes available capital to carry on a larger and more profitable business.
B. From the shareholder’s view point:

(1) Immediately realizable: bonus shares can be sold in the market immediately after a
shareholder gets it.

(2) Not Taxable: Bonus shares are not taxable.

(3) Increase In Future Income: shareholders will get dividend on more shares than earlier in
future.

(4) Good Image Increases The Value In Market: Bonus shares create very good image of the
company and the shares. Thereby it results into increase in the value of the share in the market.

(5 The bonus shares are a permanent source of income to the investors.

(6) If partly paid shares are converted into fully paid by issuing bonus, the shareholders need
not pay a further sum for the purpose. On the other hand, their shares become fully paid up.

***Disadvantages of issue of bonus shares/stock dividend

1. Rate of dividend decline: the rate of dividend in future will decline sharply as it is only the
capital that increases and not the actual resources of the company. The earnings do not usually
increase with the issue of bonus shares. This may create confusion in the minds of the investors.

2. Speculative dealing: It will encourage speculative dealings in the company’s shares which is
not desirable.

3. Forgoes cash equivalent: when partly paid up shares are converted into fully paid-up shares,
the company forgoes cash equivalent to the amount of bonus so applied for this purpose.

4. Lengthy procedure: Prior approval of central government through sebi must be obtained
before the bonus share issue. The lengthy procedure, sometime may delay the issue of bonus
shares.

5. The reserves of the company after the bonus issue decline and leave lesser security to
investors.
6. If the rate of profit is not increased, the rate of dividend may be decreased.
Conclusion:Declaring bonus shares is a sign that companies are increasing their profitability.
Many companies have announced issues of bonus shares to their shareholders by capitalizing
their free reserves. Shareholders have benefited tremendously, even after accounting the
inevitable reduction in share prices post-bonus, since the floating stock of shares increases. It
may be a good indicator that the company is healthy.

***legal/statutory provisions relating to declaration and payment of dividend (4 marks)

The companies act provides various rules regarding the declaration and payment of dividend.
They are summarized below:

1. Right to recommend the dividend

The right to recommend a dividend lies with the board of directors. Only when the board
recommends a dividend, the shareholders can declare a dividend in the general meeting.
However, the shareholders cannot insist the directors to recommend. Even if there are sufficient
profits, but the directors feel that a distribution of dividend is undesirable in the interests of the
financial stability of the company, they can refuse to recommend a dividend.

2. Right to declare a dividend. Only the shareholders in the Annual General Meeting can
declare the dividend. The board of directors determines the rate of dividend to be declared and
recommends it to the shareholders. The shareholders, by passing a resolution in the general
meeting, can declare the dividend. The shareholders can either accept the same rate of dividend
or they can even reduce the rate. However, they cannot enhance the rate of dividend
recommended by the directors.

3. Payable out of profits only; The company can declare and pay a dividen d only where
there is a profit. In other words, dividend is payable only out of profits. If there is no profit,
there can be no distribution of dividend. The companies act provides that a dividend can be
paid only:1. Out of the profits of the current finan cial year, or,2. Out of the profits of the
previous years, or 3. Out of moneys provided by the central or state governments for the
purpose of paying a dividend.
Therefore, if a dividend is paid out of capital, it amounts to a breach of trust. It amounts to an
unauthorized reduction of capital and is ultra vires. Hence, void. The directors shall become
jointly and severally liable.

4. Provision for depreciation; It is already stated that a dividend can be declared only out of profits.
The profits should be arrived only after providing for depreciation for the current year and also for all the
arrears of depreciation or loss in any previous year]. However, the central government can exempt any
company from this obligation in the interest of the public.

5. Setting off the previous losses If any loss is incurred in any previous year after 1960,
such loss should be set off against the profits of the current year before declaring a dividend
6. Payable only in cash; The dividend is payable only in cash. However, a company is not
prohibited from capitalizing its profits or reserves by the issue of bonus shares or by making
partly paid up shares into fully paid up shares.

7. Time limit for payment: When a dividend is declared, it should be paid within 30 days from
the date of declaration. The dividend when declared shall become a debt due from the company.
If the company does not pay the dividend within the period, every person who is a party to the
default is punishable with simple imprisonment up to seven days and also with a fine.
8. Unpaid dividend account If a dividend is declared but not paid within 7 days from the date of
expiry of the 30 days, should transfer the amount of unpaid dividend to a separate account with
any scheduled bank opened under the style “unpaid dividend account of………company ltd“.

9. Transfer to general revenue account: Any amount transferred to the unpaid dividend
account, which remains unpaid or unclaimed for a period of three years, should be transferred by
the company to the general reserve account of the central government. However, the person to
whom the dividend is payable can claim the money from the central government. The company
which transfers any amount to the general reserve account should furnish a statement furnishing
the nature of amount, names of the persons entitled to receive the amount, their addresses, amount
due to them, etc.