CHAPTER ONE:

DIVIDEND POLICY AND THEORY

• Dividend The distribution of a company's earnings to its shareholders.
• Determined by the company's board of directors.
• Paid out as cash or in the form of reinvestment in additional stock.
• A way for shareholders to earn money from an investment without selling
shares.
• Usually paid on a regular basis (monthly, quarterly, semi-annually, or
annually).
11. TYPES OF DIVIDENDS

Dividend may be distributed among the shareholders in the form of cash or stock.
Hence, dividends are classified into:

Cash dividend

Stock dividend

Bond dividend

Property dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business enterprises EAIT (Earnings after interest and tax). Cash dividends
are common and popular types followed by majority of the business enterprises. Cash dividends
return profits to the owners of a corporation.

When cash dividend is distributed, both total assets and net worth of the company decrease.
Total assets decrease as cash decreases and net worth decreases as retained earnings decrease.
The market price per share also decreases in most cases by the amount of cash dividend
distributed. Market price per share after cash dividend = Marker price per share before cash
dividend - dividend per share.

The basic types of cash dividends are as follows:

A. Regular cash dividend

B. Extra cash dividend

C. Special dividend
D. Liquidating dividend

A. Regular Cash Dividend

It is the dividend that is normally expected to be paid by the firm. The most common type of
cash dividend is a regular cash dividend, which a cash payment is made by a firm to its
stockholders in the normal course of business. Most dividend paying companies issue a regular
cash dividend four times a year.

B. Extra Cash Dividend

A nonrecurring dividend paid to shareholders in addition to the regular dividend. It may or may
not be repeated in the future.

C. Special Dividends

A special dividend, like an extra dividend, is a one-time payment to stockholders. It is tend to be

considerably larger than extra dividend and to occur less frequently. They are used to distribute
unusually large amounts of cash. Liquidating Dividend Another form of dividend is a liquidating
dividend, which is any dividend, not based on earnings. It is a dividend that is paid to
stockholders when a firm is liquidated. It implies a return of the stockholders’ investment rather
than of profits. For example, liquidating dividends may result from selling off all or part of the
business and distributing the funds to shareholders.

D. Stock Dividend
Stock dividend – is a payment of additional shares of stock to shareholders. It is often used in
place of or in addition to a cash dividend. It is one type of “dividend” that does not involve the
distribution of value.

When a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to
existing stockholders.

Advantages

The important benefits derived from stock dividend or issue of bonus shares are as follows:

 It preserves the company's liquidity as no cash leaves the company.

 The shareholders receive a dividend which can be converted into cash whenever he
wishes through selling the additional shares.
 It broadens the capital base and improves image of the company.
 It reduces the marker price of the shares, rendering the shares more marketable.
 It is an indication to the prospective investors about the financial soundness of the
company.
 The shareholders can take the advantage of tax saving from stock dividend.
Disadvantages

 The future rate of dividend will decline.

 The future market price of share falls sharply after bonus issue.
 Issue of bonus shares involves lengthy legal procedures and approvals.

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.

Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distribute under the
exceptional circumstance.

Benefits and Costs of Dividends

The benefits associated with dividends are as follows:

 Dividends may attract investors who prefer to receive income directly from their
investments. However, the tax costs of dividends may drive away other investors.
 Dividends can function as a signal to investors that the company is performing well and
has higher than expected cash flows.
 Dividends can help align manager and stockholder incentives. By issuing dividends and
raising capital through equity issues (rather than internal funds), managers are subject to
more scrutiny.
 This increases the incentives for managers to perform well.
 Dividends reduce equity claims on the company; this can help managers achieve the
target capital structure suggested by the trade-off theory.

Some costs associated with dividends include:

 Taxes: Dividends have historically taxed at a higher rate than other forms of income.
 Reinvestment costs: Investors who don’t intend to spend the cash must pay the
transactions costs associated with reinvesting (brokerage fees, etc.).
 Increased cost of debt: By reducing the amount of equity through a dividend issue, the
firm becomes more leveraged. If the increase is significant, this could increase the risk
associated with the company and increase the cost of debt should the company desire to
borrow.
Dividend Payment Procedure
A corporation’s board of directors is ultimately responsible for a firm’s dividend policy. This
policy could vary from zero to 100 percent payout of earnings. A corporation has no legal
obligation to declare a dividend. After the board declares a dividend, the declared cash dividend
becomes a liability and the corporation has a legal obligation to make the payment. Once the
board sets the dividend, the procedure for paying the dividend is routine. In chronological order,
the four important dates associated with a dividend payment are as follows.

Declaration date

The declaration date is the date when the board of directors announces the dividend payment.

Ex-dividend date

The ex-dividend date is the cut-off date for receiving the dividend. That is, the ex-dividend date
is the first date on which the right to the most recently declared dividend no longer goes along
with the sale of the stock. Companies and exchanges report the ex-dividend date to remove any
ambiguity about who will receive a dividend after the sale of a stock. Investors who buy the
stock before the ex-dividend date are entitled to the dividend, while those who buy shares on or
after the ex-dividend date are not.

Record date

The record date is the date on which an investor must be a shareholder of record to be entitled to
the upcoming dividend. The brokerage industry has a convention that new shareholders are
entitled to dividends only if they buy the stock at least two business days before the record date.
This rule allows time for the transfer of the shares and gives the company sufficient notice of the
transfer to ensure that new stockholders receive the dividend. Therefore, a stock sells ex-
dividend two business days, not calendar days, before the record date. The board of directors sets
the record date, which is typically several weeks after the declaration date.

Payment date

The payment date is the date when the firm mails the dividend checks to the shareholders of
record. This date is usually several weeks after the record date.
Example 1

On June 30, 2009, XYZ Company declared a dividend of Br. 5 per share, payable on September
1 to the holders of record on August 1. Show the XYZ’s dividend payment procedure.

Solution

Declaration date: June 30, 2009 on which XYZ Company's board of directors declared a
dividend of Br. 5 per share.

Ex-dividend date: July 30, 2009 after which dividends are entitled with the seller of the stock.

The record date: August 1, 2009 on which company makes a list of shareholders who are entitled
to receive dividend.

Payment date: September 1, 2009 on which XYZ Company mails the cheque of dividends to the
shareholder.

2 days

30-6-2009 30-7-2009 1-8-2009 1-9-2009

Declaration date Ex-dividend date Holder-of-record date Payment date

1.2. FACTORS INFLUENCING DIVIDEND POLICY

Dividend policy is concerned with determining the proportion of firm's net income to be
distributed in the form of dividend and the proportion of earnings to be retained for investment
purpose. A firm's dividend policy is influenced by a number of factors. Some of the major
factors influencing the firm's dividend policy are as under:

Some of the major factors influencing the firm's dividend policy are as under:

A. Profitable Position of the Firm F. Growth Rate of the Firm

G. Tax Policy

H. Access to the Capital Market

I. Desire of Shareholders

J. Cost of External Financing

K. Degree of Control
B. Sources of Finance

C. Stability of Earnings

D. Legal Constrains

E. Liquidity Position

Profitable Position of the Firm

Dividend decision depends on the profitable position of the business enterprise. When the firm
earns more profit, they can distribute more dividends to the shareholders.

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.

Stability of Earnings

The stability of earnings also effects the dividend policy decision. If the earnings of a firm are
relatively stable, the firm is more likely to payout a higher percentage of earnings than the firm
which has fluctuating earnings.

Legal Constrains

There are certain legal rules that may limit the amount of dividends a firm may pay. Following
are the rules relating to dividend payment:

Net profit rule: According to this rule, dividends can be paid out of present or past earnings.

Amount of dividends cannot exceed the accumulated profits. If there is accumulated loss, it must
be set off out of the current earnings before paying out any dividends.

Insolvency rule: According to this rule, a firm cannot pay the dividends when its liabilities
exceed assets. When the firm's liabilities exceed its assets, the firm is considered to be financially
insolvent. The firm, financially insolvent, is prohibited by law to pay dividends.

Capital impairment rule: - According to this rule, a firm cannot pay dividend out of its paid up
capital. The dividend payout that impairs capital is considered illegal.

Liquidity Position

In order to pay dividend, a company requires cash, and, therefore, the availability of cash
resources within the company will be a factor in determining dividend payments. Generally, the
greater the cash position and overall liquidity of a company, the greater is the ability to pay
dividends. A company must have adequate cash available as well as retained earnings to pay
dividends. The liquidity position of the company will influence the dividend payout of a
particular year.

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.

Growth Rate of the Firm

High growth rate implies that the firm can distribute more dividends to its shareholders.

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.

Access to the Capital Market

The company, which has a good access to capital market, can follow a liberal dividend policy
because this type of the company can raise the required funds from the capital market.

Desire of Shareholders

Dividend policy is affected by the desire of shareholders. Shareholders may be interested either
in dividend income or capital gain. Wealthy shareholders may be interested in capital gain as
against dividend income because of low tax rate on capital gain. Whereas the shareholders,
whose sources of income is dividend only, are interested in dividend income and would not be
interested in capital gain.

Cost of External Financing

The cost of external financing will have impact on the dividend payout of a company. In
situations, where the external funds are costlier, a firm may resort to low dividend payout and
use the internal funds for financing its business.

Degree of Control

One of the important influencing factors on dividend policy is the objective of maintaining
control over the company by the existing management or shareholders. The management who
wish to maintain close control over the company will not much depend on the external sources of
finance, and they maintain a low dividend payout policy and the funds generated from operations
would be used for working capital and capital investment needs of the firm.
Tax Position of Shareholders

The tax position of shareholders also influences dividend policy. The company owned by
wealthy shareholders having high income tax bracket tend toward lower dividend payout
whereas the company owned by small investors tend toward higher dividend payout.

1.3. ESTABLISHING DIVIDEND POLICY

Dividend policy is an important topic because dividends represent major cash outlays for many
corporations. Dividends are at the heart of the difficult choice that management must make in
allocating their capital resources: reinvesting the money within the company or distributing it to
shareholders. Although paying dividends directly benefits stockholders, it also affects the firm’s
ability to retain earnings to exploit growth opportunities. Dividend policy provides guidelines for
balancing the conflicting forces surrounding the dividend payment versus retention decision.

Dividend policy refers to the payout policy that management follows in determining the size and
pattern of distributions to shareholders over time. The dividend policy question centers on the
percentage of earnings that a firm should pay out.

A finance manager’s objective for the company’s dividend policy is to maximize owner wealth
while providing adequate financing for the company. When a company’s earnings increase,
management does not automatically raise the dividend. Generally, there is a time lag between
increased earnings and the payment of a higher dividend. Only when management is confident
that the increased earnings will be sustained will they increase the dividend. Once dividends are
increased, they should continue to be paid at the higher rate.

1.4. TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and profitable position.
On the basis of the dividend declaration by the firm, the dividend policy may be classified under
the following types:

Residual Dividend approach

Dividend stability

A Compromise

A. Residual-dividend policy: Residual dividend policy is based on the assumption that investors
prefer to have a firm retain and reinvest earnings rather than pay out them in dividends. Under
residual dividend policy, a firm pays dividend only after meeting its investment need. Under
residual dividend policy, if the net income exceeds the portion of equity financing, then the
excess of net income over equity need is paid as dividend. The company does not pay any
dividend when net income is less than or equal to equity need for financing the investment
proposals. In case, net income is not sufficient to meet equity need, the company should raise
deficit amount by external equity.

When a company’s investment opportunities are not stable, management may want to consider a
fluctuating dividend policy. With this kind of policy the amount of earnings retained depends
upon the availability of investment opportunities in a particular year. Dividends paid represent
the residual amount from earnings after the company’s investment needs are fulfilled.

B. Stable dividend-per-share policy Stable dividend policy means payment of certain minimum
amount of dividend regularly. Many companies use a stable dividend-per-share policy since it is
looked upon favorably by investors. Dividend stability implies a low-risk company. Even in a
year that the company shows a loss rather than profit the dividend should be maintained to avoid
negative connotations to current and prospective investors. By continuing to pay the dividend,
the shareholders are more apt to view the loss as temporary. Some stockholders rely on the
receipt of stable dividends for income. A stable dividend policy is also necessary for a company
to be placed on a list of securities in which financial institutions (pension funds, insurance
companies) invest. Being on such a list provides greater marketability for corporate shares.

C. A compromise policy A compromise between the policies of a stable dollar amount and a
percentage amount of dividends is for a company to pay a low dollar amount per share plus a
percentage increment in good years. While this policy affords flexibility, it also creates
uncertainty in the minds of investors as to the amount of dividends they are likely to receive.
Stockholders generally do not like such uncertainty. However, the policy may be appropriate
when earnings vary considerably over the years. The percentage, or extra, portion of the dividend
should not be paid regularly; otherwise it becomes meaningless.

Practical Considerations in Setting a Dividend Policy

A company’s dividend policy is largely a policy about how the excess value in a company is
distributed to its stockholders.

It is extremely important that managers choose their firms’ dividend polices in a way that
enables them to continue to make the investments necessary for the firm to compete in its
product markets.

Managers should consider several practical questions when selecting a dividend policy:

Over the long term, how much does the company’s level of earnings (cash flows from
operations) exceed its investment requirements? How certain is this level?

Does the firm have enough financial reserves to maintain the dividend payout in periods when
earnings are down or investment requirements are up?
Does the firm have sufficient financial flexibility to maintain dividends if unforeseen
circumstances wipe out its financial reserves when earnings are down?

Can the firm raise equity capital quickly if necessary?

If the company chooses to finance dividends by selling equity, will the increased number of
stockholders have implications for control of the company?

REPURCHASE OF STOCK

Stock repurchase is method in which a firm buys back shares of its own stock, thereby
decreasing shares outstanding, increasing earnings per share, and, often increasing the stock
price. It is an alternative to cash dividends. In a stock repurchase, the company pays cash to
repurchase shares from its shareholders. These shares are usually kept in the company's treasury
and then resold when the company needs money.

If a firm has excess cash, it may purchase its own stock leaving fewer shares outstanding,
increasing the earning per share and increasing the stock price. It may be an alternative to paying
cash dividends. The benefits to the shareholders are the same under cash dividend and stock
repurchase. In the absence of personal income taxes and transaction costs, both cash dividend
and stock repurchase have no any difference to shareholders. Capital gain arising from
repurchase should equal the dividend otherwise would have been paid.

Share can be repurchased in different ways. A company can repurchase its shares through
authorized brokers on the open market. Shares can be also repurchased by making a tender offer
which will specify the purchases price, the total amount and the period within which shares will
be bought back. Similarly, a company can purchase a block of shares from one large holder on a
negotiated basis.

Advantages of repurchase of stock

A firm can use idle cash to repurchase stock if it has less investment opportunities.

Dividend and earnings per share will be increased through stock repurchase.

Stock repurchase will result in increase in the share value.

The buying shareholders will benefit since the company generally offer a price higher than the
current market price of the share.

When shares are undervalued in the market, a company can buy back shares at higher price to
move up the current share price.

If a company has high proportion of equity in its capital structure, if can reduce equity capital by
buying back its shares to achieve target capital structure.
The promoters of the company benefit by consolidating their ownership and control over
companies through stock repurchase. They do not sell their shares to the company rather make
the share repurchase attractive for others.

Repurchase of stock can remove a large block of stock that is overhanging the market and
keeping the price per share down.

In a hostile takeover, a company may buy back its shares to reduce the availability of shares and
make take over difficult.

Stockholders are given a choice of whether or not to sell their stock to the firm.

Disadvantages of stock repurchase

Shareholders may not be indifferent between dividends and capital gains, and the price of stock
might benefit more from cash dividends than from repurchase.

The remaining shareholder may lose if the company pays excessive price for the shares under the
stock repurchase scheme.

Stock repurchase may signal to investors that the company does not have long - term growth
opportunities to utilize the cash.

The buyback of shares may be useful as a defense against hostile takeover only in case of cash
rich companies.

STOCK SPLIT

A stock split is a method to reduce the market price per share by giving certain number of share
for one old share. Due to stock split, number of outstanding shares increase and par value and
marker price of the stock decrease. A stock split affects only the par value, market value and the
number of outstanding shares. However, net worth of the company remains unaltered.

With a stock split, shareholder's equity account does not change, but the par value per share
changes. The earnings per share will be diluted and market price per share fall proportionately
with a stock split. But, the total value of the holdings of a shareholder remains unaffected by a
stock split. Following are the reasons for splitting a firm's ordinary shares:

Stock split results in reduction in market price of the share. It helps in increasing the
marketability and liquidity of a company's shares.

Stock splits are used by the company management to communicate to investors that the company
is expected to earn higher profits in future.

Stock split is used to give higher dividends to shareholders.