Module IV

DIVIDEND DECISIONS
Financing an enterprise through its internal
sources is known as internal Iinancing. Such
internal resources comprise oI earnings retained
by the company in the Iorm oI income leIt over
aIter meeting all expenses. This retaining oI
earnings is technically termed as ploughing back
oI proIits.

Retained earnings constitute an important source
oI corporate Iinancing. The Iunds are relatively
economic and without any obligation to reIund
the same. These Iunds can be eIIectively utilized
Ior modernisation and expansion requirements
and that too without creating any charge against
any asset.

DIVIDEND DECISIONS
The term dividend reIers to that portion oI proIit
(aIter tax) which is distributed among the
owners/shareholders oI the company and the
proIit which is not distributed is known as
retained earnings.

II a company pays dividends, it aIIects the cash
Ilow position oI the Iirm but earns a goodwill
among the investors who thereIore, may be
willing to provide additional Iunds Ior the
Iinancing oI investment plans oI the Iirm. On the
other hand, the proIits which are not distributed
as dividends become an easily available source oI
Iunds at no explicit costs. However, in the case oI
ploughing back oI proIits, the Iirm may loose the
goodwill and conIidence oI the investors and may
also deIy the standards set by other Iirms.
ThereIore, in taking the dividend decision, the
Iinancial manage has to consider and analyze
various Iactors.

In dividend decision, a Iinancial manger is
concerned to decide one or more oI the
Iollowings :
(i) Should the proIits be ploughed back to Iinance
the investment decisions?
(ii) Whether any dividend be paid?
(iii) How much dividends be paid?
(iv) When these dividends be paid?
(v) In what Iorm the dividends be paid?

All these decisions are inter-related and have
bearing on the Iuture growth plans oI the
company.

DETERMINANTS OF DIVIDEND POLICY

The payment oI dividend involves
Iinancial as well as legal considerations.

External Factors Affecting Dividend Policy

1. General State of Economy.
O In case oI uncertain economic and business
conditions, the management may like to retain
whole or large part oI earnings to build up reserves
to absorb Iuture shocks.
O In the period oI depression the management may
also retain a large part oI its earnings to preserve
the Iirm's liquidity position.
O In periods oI prosperity the management may not
be liberal in dividend payments because oI
availability oI larger proIitable investment
opportunities.
O In periods oI inIlation, the management may retain
large portion oI earnings to Iinance replacement oI
obsolete machines.

. State of Capital Market.
O Favourable Market: liberal dividend policy.
O &nIavourable market: Conservative dividend
policy.

. egal Restrictions.

Companies Act has laid down various restrictions
regarding the declaration oI dividend: Dividends can only
be paid out oI:

O Current or past proIits oI the company.
O Money provided by the State/ Central Government
in pursuance oI the guarantee given by the Government.
O !ayment oI dividend out oI capital is illegal.
O
A company cannot declare dividends unless:
O It has provided Ior present as well as all arrears oI
depreciation.
O Certain percentage oI net proIits has been
transIerred to the reserve oI the company.
O !ast accumulated proIits can be used Ior
declaration oI dividends only as per the rules
Iramed by the Central Government
. Contractual Restrictions.
Lenders sometimes may put restrictions on the
dividend payments to protect their interests (especially
when the Iirm is experiencing liquidity problems)
Example. A loan agreement that the Iirm shall not declare
any dividend so long as the liquidity ratio is less than 1:1.
The Iirm will not pay dividend more than 20 so long as it
does not clear the loan.

Internal Factors affecting dividend decisions
1. esire of the Shareholders.
Though the directors decide the rate oI dividend, it is
always at the interest oI the shareholders.
Shareholders expect two types oI returns:
|i| Capital Gains: i.e., an increase in the market value oI
shares.
|ii| Dividends: regular return on their investment.

Cautious investors look Ior dividends because,
|i| It reduces uncertainty (capital gains are uncertain).
|ii| Indication oI Iinancial strength oI the company.
|iii| Need Ior income: Some invest in shares so as to get
regular income to meet their living expenses.

. inancial Needs of the Company.
II the company has proIitable projects and it is costly to
raise Iunds, it may decide to retain the earnings.

. Nature of earnings.A company which has stable
earnings can aIIord to have an higher divided payout ratio.

. esire to retain the control of management.
Additional public issue oI share will dilute the control oI
management.
. iquidity position.
!ayment oI dividend results in cash outIlow. A company
may have adequate earning but it may not have suIIicient
Iunds to pay dividends.
6. rowth Prospects
Another set oI Iactors that can inIluence dividend
policy relates to the Iirm's growth prospects. The Iirm is
required to make plans Ior Iinancing its expansion
programmes. In this context, the availability oI external
Iunds and its associated cost together with the need Ior
investment Iunds would have a signiIicant bearing on the
Iirm's dividend policy.

7. Control
Dividend policy may also be strongly inIluenced
by the shareholders' or the management's control
objectives. That is to say, sometimes management employs
dividend policy as an eIIective instrument to maintain
its position oI command and control. The management, in
order to retain control oI the company in its own hands,
may be reluctant to pay substantial dividends and would
preIer a smaller dividend payout ratio. This will
particularly hold good Ior companies which require Iunds
to Iinance proIitable investment opportunities when an
outside group is seeking to gain control oI the Iirm.

8. Inflation
It may also aIIect the dividend policy oI a Iirm.
With rising prices, Iunds which are generated by way oI
depreciation may Iall short in order to replace obsolete
equipment. The shortIall may be made Irom retained
earnings (as a source oI Iunds). This is very signiIicant
when the assets are to be replaced in the near Iuture. As
such, the dividend payout ratio tends to be low during the
periods oI inIlation.

FORMS OF DIVIDEND
Dividends can be distributed by a company in
various Iorms. These Iorms are cash dividends, stock
dividends, scrip dividends and bond dividends. These
Iorms oI dividends are brieIly explained as under :

(i) Cash Dividends : It is the common practice to pay
dividends in cash. These dividends are paid when proIits
are earned by an enterprise. In the event oI a company
Iollowing a policy oI stable dividends, it has to pay the
same even though the proIits oI the enterprise are small. II
this is so the company may even have to borrow to meet
the Iund requirement Ior dividend payment.

(ii) Stock Dividend : Such dividend payment in India is
know as bonus shares. This is an alternative Iorm oI
dividend payment. In this case the current shareholders get
their share oI dividends by way oI share distribution. Such
a distribution may be either in lieu oI cash dividend or it
may be in addition to the cash dividend. Stock dividends
are distributed in the proportion oI shareholding with the
result there is no change in the ownership proportion oI the
shareholders. The payment by way oI stock dividends does
not change the net worth oI the company.

( i i i ) Scrip Dividend : This is another Iorm oI dividend
whereby the dividend is paid by a company in the shape oI
a scrip or a promissory note. The document bears a
maturity date and when it reaches this date the stated
payment is made in cash.

(iv) Bond Dividend : This Iorm oI dividend payment also
is not popular in India. This is just like a scrip dividend
wherein bonds are issued by a company when despite
suIIicient earnings the Iinancial position oI the company is
tight. The bonds are issued in lieu oI dividend payments.
But, as against scrip dividends bonds carry a long maturity
period.

(v) Property Dividends
This Iorm oI dividend is unusual. Such dividend may be in
the Iorm oI inventory or securities in lieu oI cash payment.
A company sometimes may hold shares oI other
companies, e.g., its subsidiaries that it may like to
distribute among its own shareholders, instead oI paying
dividend in cash. In case the company sells these shares it
may have to pay capital gains, which may be subject to
taxation. II these shares are transIerred to its shareholders,
there is no tax liability.

APPROACHES TO DIVIDEND DECISION
Various models have been proposed to evaluate the
dividend policy decision in relation to value oI Iirm. They
are:

1. Irrelevance oI Dividend !olicy
The dividend irrelevance theory is a concept that is based
on the premise that the dividend policy oI a given company
should not be considered particularly important by
investors. Further, the terms oI that dividend policy should
not have any bearing on the price oI the shares oI stock
issued by that company. With this particular Iinancial
theory, the idea is that investors can always sell a portion
oI their shares iI they want to generate some amount oI
cash Ilow.
Modiglilani -Miller Model

Modigliani-Miller have propounded the MM hypothesis to
explain the irrelevance oI the Iirm's dividend policy. This
model which is based on a Iew assumptions, sidelined the
importance oI the dividend policy and its eIIect thereoI on
the share price oI the Iirm. According to the model, it is
only the Iirms' investment policy that will have an impact
on the share value oI the Iirm and hence should be given
more importance.
Assumptions
1. existence oI a perIect market in which all
investors are rational.
2. There are no taxes implying that there is no
diIIerential tax rates Ior the dividend income and
the capital gain.
3. a Iirm has a given investment policy which does
not change.
4. the investors are able to Iorecast the Iuture
earnings, the dividends and the share value oI the
Iirm with certainty.

2. Relevance oI Dividend !olicy.

The bird-in-the-hand theory,( Dividend Irrelevance
Theory) however, states that dividends are relevant.

The theory implies that retained earnings belong to the
shareholders oI the company and shareholders are not
concerned whether money is used to pay out dividends or
Ior investment purposes because they beneIit either way by
receiving dividends or via share price appreciation.

A. 1 Walter Model

The dividend policy given by James E Walter considers
that dividends are relevant and they do aIIect the share
price. In this model he studied the relationship between the
internal rate oI return (r) and the cost oI capital oI the Iirm
(k), to give a dividend policy that maximizes the
shareholders' wealth.

Assumptions : The relevance oI the dividend policy as
explained by the Walter's Model is based on a Iew
assumptions, which are as Iollows :
(i) Retained earnings is the only source oI Iinance
available to the Iirm, with no outside debt or additional
equity used.
(ii) r and k are assumed to be constant and thus additional
investments made by the Iirm will not change its risk and
return proIiles.
(iii) Firm has an inIinite liIe.
(iv) For a given value oI the Iirm, the dividend per share
and the earnings per share remain constant.
Walter's Iormula shows that the market value oI a share
is the present value oI the expected stream oI dividends
and capital gains.
. ordon's Dividend Capitalization Model
Yet another model that has given importance to the
dividend policy oI the Iirm is the Gordon Model. Myron
Gordon used the dividend capitalization approach to study
the eIIect oI the Iirm's dividend policy on the stock price.
The model is however, based on the Iollowing assumptions
:
Assumptions : The Iollowing are the assumptions based
on which Gordon gave the dividend policy Ior Iirms :
(i) The Iirm will be an all-equity Iirm with the new
investment proposals being Iinanced solely by the retained
earnings.
(ii) Return on investment (r) and the cost oI equity capital
(ke) remain constant.
(iii) Firm has an inIinite liIe
(iv) The retention ratio remains constant and hence the
growth rate also is constant (gbr).

Gordon's Model assumes that the investors are rational and
risk averse. They preIer certain returns to uncertain returns
and thus put a premium to the certain returns and discount
the uncertain returns. Thus, investors would preIer current
dividends and avoid risk. Retained earnings involve risk
and so the investor discounts the Iuture dividends. This
risk will also aIIect the stock value oI the Iirm.