Divident Policy

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 payment until some conditions met.

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

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