Bhupendra Pt Singh Imrt B School Lucknow-divident-policy

Presented by : BHUPENDRA PRATAP SINGH

Introduction Net earning has two parts- Retained earning

and Dividends Retained earning used for further investment Dividends are paid in cash to shareholders Dividend increases the value of share

Practical Consideration in Paying Dividends Depend upon firms financial needs, growth

plans and investment opportunity Signaling information about prospects of

the company Investor preference for dividend than capital receipts for his own investments Control over the company may be lost Resolution of investors uncertainty Ability to raise additional finance Closely / Widely Held Company

Firm’s need for fund Growing firm generally keep major proportion of net

earning. Growth firms have large number of investment opportunity hence they should give precedence to retention of earning. Matured firms have infrequent investment opportunity hence they should distribute most of their earning. It is argued that when IRR (return on investment) is greater than cost of capital, it is profitable to reinvest the net earning or most of it. Retained earnings are preferred than external equity as they does not involve floatation costs. Some companies prefer to raise external equity for financing investment decision.

Investor preference for dividend than capital receipts Some shareholder’s may prefer near

dividends than future dividend or capital gain. Depends upon economic status, the effect of tax differential on dividends and capital gains. In closely held companies, director knows shareholder’s expectations well and frame dividend policy accordingly. Institutional investors avoid speculation

Control over the firm If dividends are paid, cash may affected For further expansion company may have to

issue new share The control of existing shareholders will be diluted if they do not want or cannot buy new shares Hence payment of dividend may withheld and earning may be retained

Investor preference for dividend than capital receipts Widely held companies : Small investors,

Retired or old person and Wealthy investors. Shareholder’s income may go against company’s investment and long term growth Management should properly trade off between dividend and retained earning

Resolution of investors uncertainty Dividends have informational value. It resolves uncertainty in the mind of investor. Companies generally have to pay small

amount of income even when earnings fall. It conveys that future of the company is bright.

Other Practical Consideration in Paying Dividends Risk taking capability of firm Firm’s constraints- financial and legal. Policy of the company: whether stable

dividend per share or payout ratio Liquidity requirement Taxation treatment

Other Practical Consideration in Paying Dividends Temporary excess cash on account of windfall

gains and not the better investment option available to firm

Capital Budgeting decision- If policy is independent (No impact) - If Dependent (Higher payout means lower

capital budgeting)

Stability of dividends It has the positive effect on market price of

the share. It also mean regularity in paying some dividend annually. Three forms of dividend stability Constant dividend per share (dividend rate) Constant payout Constant dividend per share plus extra dividend.

Constant dividend per share In India, companies announces dividend as a

percent of the paid-up capital per share. Dividend rate may increase. EPS

EPS & DPS

DPS

Time

Constant Dividend per Share plus Extra Dividend Generally adopted by companies with

fluctuating earnings. Policy to pay a minimum dividend per share with a step up feature. Paying extra in period of prosperity. Known as interim dividend with final dividend. It helps in paying dividend without a default.

Merits of stability of dividends It has several advantages. Resolution of investors uncertainty. Investors’ desire for current income. Institutional investors requirements. Raising additional finances.

Danger of stability of dividends Once established, difficult to change. It creates a clientele that depends on it. Have to maintain the stability even during

lean years. Hence dividend rate should be fixed at conservative figures.

Constant Payout The rate of dividend to earning is known as

payout ratio. Some company may follow a policy of constant payout ratio. Paying a fixed percentage of earning per year. Amount of dividend fluctuates in direct proportion to earning. In losses, no dividend shall be paid.

Constant Payout EPS EPS and DPS

DPS

Time

Constraints on paying dividends A high leveraged firm expected to retain

more to strengthen its position. Raising much external equity will adversely affect the firm’s financial flexibility. Financial flexibility includes the firm’s ability to access external funds at later date. Access to capital market. Restriction in loan agreements. Lenders may put restrictions on dividend

Issues in dividend policy Low policy payout may produce higher

share price but not always Dividend is a current earning while capital gain is a future earning Dividend yield = dividend per share/ market price per share Dividend are generally taxed more than capital gain

Legal and procedural aspects to be considered in dividend policy Companies can only pay cash dividend (with

the exception of bonus shares) Dividend can not be declared for past years Dividend can be declared out of the profit of the same financial year and after providing for the government dues and depreciation under companies act

Conclusion Don’t pay dividend on the expense of new

project can give better returns than cost of equity Try to avoid the new equity raising Frame dividend policy based on - Targeted debt-equity ratio - Investment needs of the company - Capital market norms and tax code - Avoid dividend cuts

Thank YOU You