DIVIDEND

Dividend is a part of profit distributed to the shareholders. Dividend is a periodic reward

given by a company to its shareholders for their investment. Dividend is recommended by the
board of directors and declared in the general meeting.

According to the Institute of Chartered Accounts of India, “dividend is a distribution to the

shareholders out of profits or reserves available for the purpose”.

TYPES OF DIVIDEND

Dividend may be given to the shareholders in the following forms.

1. Cash Dividend: Cash dividend is a type of dividend in which dividend is paid in the
form of cash. Commonly dividend is paid in cash. Cash dividends are declared and
paid at the end of the financial year. After preparing final accounts, when the directors
find that the company has divisible surpluses and sufficient cash balance to pay
dividend, they declare dividend.
2. Stock Dividend: Companies with divisible profits but not having sufficient cash
balance to pay dividend may issue shares to the existing shareholders. This is called
stock dividend or bonus issue. The shareholders get bonus shares free of cost. Thus,
stock dividend or bonus issue implies the conversion of profits into capital.
3. Scrip Dividend: Instead of paying dividend in cash or shares, companies may issue
transferable promissory notes for the amount payable to shareholders. Such
promissory notes have shorter maturity periods. This is called scrip dividend.
4. Bond Dividend: When dividend is paid in the form of debentures or bonds with long
term maturity period and fixed interest rate, it is called bond dividend)
5. Property Dividend: In rare cases, dividend may be paid in the form of asset instead
of paying dividend in cash. This is adopted normally in the case of liquidation of
companies.

DIVIDEND POLICY

Dividend policy refers to the policy of management concerning the quantum of profits
distributed among the shareholders and how much to be retained in the business for
investment. It also known as dividend decision.
In the words of Weston and Brighem, "Dividend policy determines the division of earnings
between payments to shareholders and retained earnings".

The components of Dividend policy are; 1) Dividend and 2) Retained Earninigs.

DIVIDEND PAYOUT RATIO AND DIVIDEND RETENTION RATIO

Dividend Payout Ratio denotes the portion of profit distributed among the shareholders
out of the profits generated by a company. The balance of profit which is not distributed
is retained in the business for future requirements. Thus, Retention Ratio represents
the volume of profit remaining with the company as undistributed. Dividend Payout Ratio
and Retention Ratio are computed as follows.

Dividend Payout Ratio =Dividend per share (DPS) / Earnings per share (EPS)

Retention Ratio = EPS – DPS/EPS

Dividend Payout Ratio + Retention Ratio = 1 or 100%

CONSERVATIVE DIVIDEND POLICY AND LIBERAL DIVIDEND POLICY

Conservative dividend policy is one where the management distributes only a few portion of
profit as dividend in spite of excessive profit earned. Under this policy major part of the
whole profit is reinvested in the business and shareholders are paid minimum possible
dividend.

Liberal Dividend Policy is a policy of distributing a major part of its earnings to its
shareholders as dividend and retains a minimum amount as retained earnings. Thus, the ratio
of dividend distribution is very large as compared to retained earnings.

Conservative Dividend Policy Liberal Dividend Policy

Low Payout Ratio High Payout Ratio

High Retention Ration Low Retention Ration

The main aim is capital appreciation The main aim is to provide regular income

The shareholders are benefitted in long run The shareholders are benefitted in short run
 TYPES OF DIVIDEND POLICY

Dividend policy involves a decision regarding the dividend payout ratio and retention ratio.
There are different types of policies related to the dividend which the company can follow.

Four most important types of dividend policy are –

1. Regular dividend policy

2. Stable Dividend Policy
3. Irregular Dividend Policy
4. No Dividend Policy

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.

Stable dividend policy: The term stability means consistency or lack of variability in the
stream of dividend payments. In stable dividend policy, minimum amount of dividend is paid
regularly. The stable dividend policy can be in any of the following forms

a) Constant dividend per share: According to this policy, the company pays a certain
fixed dividend per share year after year irrespective of their level of earnings. This
policy is most suitable to those companies whose earnings are expected to remain
stable over a number of years. The company which follow this policy must create a
'Reserve for Dividend Equalisation' to enable them to pay fixed dividend, even in the
period when earnings are not enough or negative.
b) Constant pay out ration: Constant pay out ratio means payment of fixed percentage
of net earnings as dividend every year. In constant pay out ratio the amount of
dividend is not fixed but it fluctuates in direct proportion to the earnings of the
company. This policy is most preferable by almost all firms because it is related to
their ability to pay dividend.
 c) Stable rupee dividend plus extra dividend: In this policy, the firms usually pay
constant low dividend per share every year plus an extra dividend in the years of high
profits. This policy is suitable to those firms whose earnings are fluctuating from year
to year.

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.

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.

RETAINED EARNINGS / PLOUGHING BACK OF PROFIT

Ploughing back of profits or retained earnings is a technique of financial management in

which all the profits of a company are not distributed among the shareholders, but part of the
profit is retained in the business for reinvestment. The part of profit retained in the business
year after year is known as ploughing back of profit or retained earnings. The amount
retained in the business is utlised for further investment. Hence, it is referred to as “Self
Financing”, “Internal Financing”, or “Inter Financing”.

Retained earnings are the amount of profit a company has left over after paying all its direct
costs, indirect costs, income taxes and its dividends to shareholders.

INTERIM DIVIDEND AND ANNUAL DIVIDEND

Interim dividend is the dividend which is declared between two annual general meetings of a
company. Final dividend is the dividend which is declared at the annual general meeting of
the company.
 BASIS FOR
INTERIM DIVIDEND FINAL DIVIDEND
COMPARISON

Meaning Interim dividend is one that is Final dividend implies the dividend
declared and paid in the middle of declared by the board of directors, at
an accounting year, i.e. before the the company's Annual General
finalization of accounts for the Meeting, after the close of financial
year. year.

Announcement Announced by the company's Recommended by the Board at the

Board of Directors board meeting and announced by the
Members of the company at the AGM

Time of declaration Before preparation of financial After preparation of financial

statements. statements.

Revocation It can be revoked with the consent It cannot be revoked.

of all shareholders.

Rate of dividend Less Comparatively higher

Articles of It is declared only when the It does not require any specific
Association articles specifically permits the provision in the articles.
declaration.

FACTORS INFLUENCING DIVIDEND POLICY

The prominent factors influencing the dividend policy (Determinants Dividend Policy) of a
company may be categorized as follows.

Internal Factors

Those factors which would influence the dividend policy and are related to the company itself
can be classified as intemal factors. The important among them are

1. Volume and Consistency of Profit: The profit generated is the prime factor which
determines dividend policy. Companies with stable and adequate earnings would
expect the same too, so that they may follow a liberal dividend policy. On the other
hand, a company with low profits or with instability of income may hesitate to adopt
liberal dividend policy.
2. Liquidity Position: Since dividend payment involves outflow of cash, liquidity
position of the company will influence dividend decision. A company may face cash
shortage even when it has generated good profits. Similarly, a growing concern
 requires more funds to avoid liquidity problems. Therefore, such companies will try to
defer dividend payment to future.
3. Attitude of Management: The management which does not like dilution of control
over the company will not depends more on external sources of finance because more
debt capital might lead to external Interventions. Therefore, such companies will keep
more reserves for future requirements and will adopt a conservative dividend policy
4. Past Dividends: Companies normally have a track record of dividend declarations
and payments. To a certain extent, such factors will influence the dividend policies.
Similarly, the rates of dividend declared by similar companies or competitors also
influence dividend decisions.
5. Availability of Loans and Capacity to Borrow: Big companies have easy
accessibility to capital market and enjoy better borrowing capacity than new ones.
Such established companies arrange funds from external sources and adopt a regular
dividend payment policy. However, a new company may not be able to declare
dividend regularly due to its difficulty to mobilize external funds easily.
6. Maturity of Debts : A company which has to redeem its debts immediately may
hesitate to declare dividend even if there is divisible profit. As the redemption of long
term debts and debentures, causes huge cash outflows, maturity time of such debts
will influence the dividend payment.
7. Investment Opportunities: Companies with good investment opportunities will try
to retain their earnings maximum. On the other hand, there are industries in which
further investment is difficult and companies in such industries will adopt a liberal
dividend policy so that the shareholders can divert the dividends to other investment
avenues.
8. Growth Phase of the Company: Companies at the early stages of growth, will retain
profits as far as possible to meet their expansion requirements. When established
companies adopt a liberal dividend policy. companies operating in grown up
industries may be able to follow a consistent dividend payout policy

External Factors

The following external factors also influence the dividend policy of a company.

1. Legal Requirements: The existing law related to declaration and payment of

dividend are to be considered while framing the dividend policy. In addition to the
 provisions in the Companies Act in this respect, existing tax laws are also
important
2. General Economic Conditions: The general economic conditions of the country
are important in framing the dividend policy. For example, a company may
hesitate to declare dividend during recession periods. On the other hand, a
company will be forced to pay more dividends during inflationary periods as the
shareholders will expect more income to maintain their liquidity. Moreover, if the
economic trends are unpredictable, companies will not adopt a liberal dividend
policy.
3. Government Policies: Government policies have direct impact on the earnings
and growth of business concerns, particularly the corporate sector. Therefore,
changes in fiscal policies, monetary policies, industrial policies, labour policies,
etc., will influence the dividend payout of the companies
4. Capital Market Conditions: If the conditions in the capital market are
comfortable and fund mobilization is easy, companies will adopt a liberal
dividend policy. Conversely, under stringent capital market situations, companies
will adopt conservative dividend policy because new issue of shares or debentures
will be difficult in such situations.

THEORIES ON DIVIDEND

Dividend Theories explain the relationship between dividend policies and value of the firm.
The following are the important theories on dividend policy.

1. Modigliani and Miller Irrelevance Theory

2. Walster‟s Model - Relevance theory
3. Gordon‟s Models

MODIGLIANI AND MILLER IRRELEVANCE THEORY

Modigliani and Miller are of the view that the value of a firm does not increase or
decrease due to dividend payment. In other words, Modigliani-Miller theory says that a
firm's dividend policy has no effect either on the value of the firm or on shareholders
wealth. The theory states that the market price of the shares of a company may increase
in the short run as a result of dividend payment. But as a result of dividend payment, the
company will be forced to raise additional funds from other sources to meet its financial
requirements for new projects. When the company makes additional issue, market value
of its shares will decline due to the additional supply of shares. As a result the increase in
the value of firm due to dividend payment gets nullified and the valuation of the firm will
be the same as it originally had. This implies that dividend payment is irrelevant in
determining the valuation of firms and hence the MM theory on dividend is also called
irrelevance theory". Modigliani and Miller conclude that payment of dividend or retention of
profit has no impact on the total valuation of the firm.

According to MM, the value of a firm depends solely on its earnings power and is not
influenced by the split of earnings in to dividend and retention. The value of shares of a firm,
is determined by its earnings potential and investment policy and not by the income
distribution pattern.

Assumptions of MM Irrelevance Theory

MM theory is based on the following assumptions.

1. The capital market is perfect and has the following features.

a. No investor is large enough to influence the market price of shares.
b. There is no transaction cost.
c. All the investors are rational.
d. All investors are well informed and information is freely available.
2. There is no tax or the rate of tax applicable on capital gains and dividend are same.
3. The firm has a fixed investment policy.
4. Risk of uncertainty does not exist so that the investors can forecast future prices and
dividends with certainty.

Criticisms of the Theory

Though the MM theory seems to be theoretically sound, it has been severely criticized
by many financial experts. The following are the major arguments against the
MM theory.

1. MM hypothesis assumes that there exist perfect capital market conditions. Practically
such a situation does not exist and hence the assumption is illogical.
 2. Another assumption is absence of floatation costs. No company can issue shares
without incurring floatation cost.
3. The theory further presumes that there is no tax. Since taxes do exist, theory
supported by no tax assumption is illogical.
4. While selling shares investors have to pay brokerage, fees, securities transaction tax,
etc., which has been ignored by the theory.
5. Most of the shareholders prefer current income rather than future capital gains.
6. Firms need not follow a fixed investment policy.

In short, all the assumptions of MM theory are unrealistic and illogical. That is why the
theory has been rejected by financial experts.

RELEVANCE THEORY – WALTER’S MODEL

Prof. James E. Walter has put forward a theory on dividend which is called "Relevance
Theory of Dividend'. Walter is of the view that dividend payment has definite impacts on
the market value of shares of companies and hence the total value of a firm will be
influenced by dividend payment. According to him investment decisions and dividend
decisions are interrelated. His model highlights the importance of the relationship between
the firms internal rate of return 'r' and its cost of capital 'ke' in framing the dividend
policy which would maximise the market value of shares and thereby the wealth of the
shareholders. Walter proves the relevance theory based on the following assumptions.

Assumptions of Walter's Model

1. The firm does not use external sources of funds for investment purposes. All the
fund
requirements are met out of retained earnings.
2. The firm's business risk remains the same irrespective of additional investments.
3. The firm's internal rate of return, r, (firm's rate of earning) and cost of capital, ke,
the rate of return expected by the shareholders) are constant.
4. Earnings and dividend remain constant.
5. The firm has perpetual life.
6. The firm distributes its entire profits as dividend or immediately invests the same
internally
Walter proves his theory classifying business firms into three categories as

1. Growth Firms

According to Walter, those firms which have lot of profitable investment opportunities
and potentials are called growth firms. In the case of such firms, the internal rate of
return, 'r' will be greater than the cost of equity 'ke' (r > ke). Walter suggests that if a
firm can earn more than what the shareholders can earn, i.e., '' is greater than 'ke', the
company should not pay dividend and should retain the entire earnings. In such cases,
the market price of share will increase along with increase in retained earnings.

2. Normal Firms

Normal firms are those which have investment opportunities but the internal rate return,
'r' will be equal to cost of equity 'ke' (r=ke) When 'r' is equal to 'ke', it implies that the
firm is earning a return which the shareholders also can earn by investing the dividend
income. Thus in the case of normal firms, where „r' is equal to 'ke' the dividend policy
has no effect on the market value of shares. The shareholders will be indifferent whether
the firm pays dividends or retains the profits

3. Declining Firms

Those firms which do not have any profitable investment opportunity are categorized as
declining firms. In the case of such firms, 'r' will be less than „ke' (r < ke). If 'ke' is
greater than r the shareholders can earn more than what the company can earn. In
such a situation, the company should distribute the entire profits as dividend. This will
enable the shareholders to reinvest their dividend income and earn better returns. Thus,
in the case of declining firms, where r < ke, the optimum dividend payout ratio is 100%.
In other words, such companies shall not retain their earnings but distribute the profits as
far as possible.

Criticisms of Walter's Model

The Walter's model explains the relationship between dividend policy and value of shares
under certain simplified assumptions. However, some of the assumptions of the theory
are illogical or relevant only in the case of very few firms. Therefore, Walter's model is
being criticized by financial experts. The following are the shortcomings of the theory.

1. Walter's model assumes that the investments are financed exclusively out of retained
earnings. In other words the model is relevant only for all equity' firms. External
sources of financing like loans, debentures and preference shares, which are relatively
low cost, has been completely ignored by the Model. Therefore, a theory which
ignores external funding is unrealistic.
2. Secondly, Walter's model assumes that the internal rate of return 'r' as constant.
This assumption is unrealistic because 'r' will not be constant always, and will be
changing based on many factors including volume of investments, market situations,
etc.
3. The theory also assumes that the rate of capitalization or cost of equity 'ke' as
constant. Practically, 'ke' will be changing due to many reasons like risk perception,
market movements, etc.

In short, as in the case of MM theory, the unrealistic assumptions and oversimplified

situations attract severe criticisms to the Walter's model and make it unpopular.

GORDON’S MODEL

Myron J. Gordon propounded a theory, somewhat similar to Walter's model, and proves
that dividend payment is relevant in determining the value of shares or value of the firm.
The theory says that the investors give preference to current incomes or dividends than
to capital appreciation in the long run. Thus the Gordon's model has been developed on
important premises as given below.

1. The firm uses equity capital alone. No external source is used and investments
are financed exclusively by retained earnings.
2. The internal rate of return „r' and the equity capitalization rate „ke' are constant.
3. The cost of capital is more than the growth rate (ke > g)
4. The firm and its stream of earnings are perpetual.
5. Corporate taxes do not exist.
6. The growth rate of the firm'g' is the product of its retention ratio 'b' and its rate of
return 'r' (g = br).
According to Gorden, the investors are rational and they wish to avoid risk always. The
term risk here refers to the possibility of not getting return on investment. The payment of
dividend removes the chances of risk. When a firm retains its earnings without paying
dividend, the investors will naturally expect a good return in future. But future is uncertain
and hence the amount and time of payment of dividend also are uncertain. Therefore, rational
investors prefer current dividend to future returns. As a result, they would discount future
dividends and give more importance to current dividend.

Gorden's Model is often described as 'bird in the hand argument, because it is based
on the proverb that “a bird in the hand is better than two in the bushes”. It implies that the
shareholders always prefer to get immediate dividend rather than better return from the
firm in future.

BONUS SHARES

Payment of dividend involves cash outflow and may affect the liquidity position of the
company. Bonus issue is a device adopted by the companies to avoid such as situation.
Thus by issuing bonus shares, the company can satisfy the expectations of the shareholders
and maintain its liquidity. In fact, bonus share is nothing but dividend paid in the form of
shares.

Bonus shares are issued by a company free of cost with the purpose of capitalizing its
profits or reserves. The issue of bonus shares will increase the paid up capital of the
company without any external transactions. As a result of bonus issue, the number of
shares will increase and hence the earnings per share of the company may decrease.
However, bonus issue does not make any change in the ownership pattern of the firm
because bonus shares are issued to the existing shareholders in the same proportion as
they hold shares currently.

Reasons for Issuing Bonus Shares

The following are the reasons which prompt a company to issue bonus shares

1. A company which has good profits but does not have sufficient liquid cash to pay
dividend will think about bonus issue
 2. A company in trouble and unable to pay its regular cash dividend will make bonus
issue instead of cash dividend.
3. Some shareholders may consider the bonus issue as the substitute of cash dividend.
4. Issue of bonus shares increases the goodwill of the company in the capital market
and build up confidence among the investors.
5. A company which has huge surpluses and wants to capitalise its reserves will resort
to bonus issue.

Features of Bonus Issue

1. Issue of Bonus Shares does not change the proportion of ownership.

2. It leads to the fall of share price in the stock market.
3. Issue of bonus shares causes decline in book value of each share.
4. The number of shares issued increases after the release of Bonus Shares.
5. Per share income decreases after the issue of bonus shares.

Advantages of Bonus Issue

1. Bonus shares allow the company to reward its shareholders with dividend, without
using its cash balance. The company can retain its cash for investment in lucrative
activities and for maintaining its liquidity.
2. A company may be under restrictions inform its creditors regarding payment of
dividends in cash. In such cases, the company may issue equity shares to keep its
shareholders in confidence.
3. Issue of bonus shares brings down the market price per share. This helps in increasing
its appeal to small investors. This may also help in increasing its turnover rate.
4. Shareholders are not liable to pay tax on bonus shares as income whereas cash
dividend is treated as income for shareholders.
5. If the company continues to pay same rate of dividend even after bonus issue, the
shareholders are entitled to higher dividend in absolute terms.
6. Bonus shares lead to increased confidence among shareholders as they facilitate
robust health of the company.

Disadvantages of Issue of Bonus Shares

Bonus shares have some shortcomings as well which are mentioned as below:

1. Bonus Ishares do not increase overall wealth of a shareholder. While the number of
shares held by a shareholder increases, the corresponding decrease in their market
value leads to unchanged shareholders' wealth.
2. Bonus shares have high cost to issue. It needs printing of new share certificates and
corresponding postal charges. Some of the shareholders may sell their shares,
increasing the number of shareholders requiring their name to be entered on the
register.
3. Issue of bonus share may lead to increased speculation.
4. A company needs to obtain various approvals including approval of the SEBI before
issuing bonus shares. These steps make the procedure of issue lengthy, exhaustive and
complicated.

RIGHT ISSUE

Right issue is an invitation to the existing shareholders to subscribe for further shares to be
issued by the company. Rights simply an option to the existing shareholders to purchase
certain securities at a price lower than the market price (privileged price) within a certain
specified period. Shares so offered to the existing shareholders are called Right Shares as the
existing equity shareholders of the public limited company have first right of further
allotment.

The offer of such shares to the existing equity shareholders is known as Privileged
Subscription or Right Issue. The prior right of the shareholders in right issue is known as Pre-
emtive Right.

STOCK SPLIT

A stock split is an action by which a company increases its number of outstanding

shares, without any change in the total capital For example, If a company had 10,00,000
shares outstanding before the split, it will have 20,00,000 shares outstanding after a two
for one split.

Reverse Split: In certain cases, a company may increase the face value of its shares by
consolidating the denomination of existing shares and such an action is called 'reverse stock
split'. In other words, the reduction of the number of outstanding shares by increasing per
share par value is known as a reverse split.