DIVIDEND: Dividends are payments made by a corporation to its

shareholder members. It is the portion of corporate profits paid out to

stockholders. When a corporation earns a profit or surplus, that money can be
put to two uses: it can either be re-invested in the business (called retained
earnings), or it can be paid to the shareholders as a dividend. Many
corporations retain a portion of their earnings and pay the remainder as a
dividend.

For a joint stock company, a dividend is allocated as a fixed amount per share.
Therefore, a shareholder receives a dividend in proportion to their
shareholding. For the joint stock company it is the division of an asset among
shareholders. Public companies usually pay dividends on a fixed schedule, but
may declare a dividend at any time, sometimes called a special dividend to
distinguish it from a regular one.

Cooperatives, on the other hand, allocate dividends according to members'

activity, so their dividends are often considered to be a pre-tax expense.

Forms of payment:

(1) Cash dividends are those paid out in the form of a cheque. Such dividends
are a form of investment income and are usually taxable to the recipient in the
year they are paid. This is the most common method of sharing corporate
profits with the shareholders of the company. For each share owned, a declared
amount of money is distributed. Thus, if a person owns 100 shares and the cash
dividend is $0.50 per share, the person will be issued a cheque for $50.

(2) Stock or scrip dividends are those paid out in form of additional stock
shares of the issuing corporation, or other corporation (such as its subsidiary
corporation). They are usually issued in proportion to shares owned (for
example, for every 100 shares of stock owned, 5% stock dividend will yield 5
extra shares). If this payment involves the issue of new shares, this is very
similar to a stock split in that it increases the total number of shares while
lowering the price of each share and does not change the market capitalization
or the total value of the shares held (see also Stock dilution).

(3) Property dividends are those paid out in the form of assets from the
issuing corporation or another corporation, such as a subsidiary corporation.
They are relatively rare and most frequently are securities of other companies
owned by the issuer, however they can take other forms, such as products and
services.

(3) Other dividends can be used in structured finance. Financial assets with a
known market value can be distributed as dividends; warrants are sometimes
distributed in this way. For large companies with subsidiaries, dividends can
take the form of shares in a subsidiary company. A common technique for
"spinning off" a company from its parent is to distribute shares in the new
company to the old company's shareholders. The new shares can then be traded
independently.

Dates:

Dividends must be “declared” by a company’s Board of Directors each time

they are paid. For public companies, there are four important dates to
remember regarding dividends.

The declaration date is the day the Board of Directors announces its intention
to pay a dividend. On this day, a liability is created and the company records
that liability on its books; it now owes the money to the stockholders. On the
declaration date, the Board will also announce a date of record and a payment
date.

The in-dividend date is the last day, which is one trading day before the ex-
dividend date, where the stock is said to be cum dividend (‘with dividend’). In
other words, existing holders of the stock and anyone who buys it on this day
will receive the dividend, whereas any holders selling the stock lose their right
to the dividend. After this date the stock becomes ex dividend.

The ex-dividend date (typically 2 trading days before the record date for U.S.
securities) is the day on which all shares bought and sold no longer come
attached with the right to be paid the most recently declared dividend. This is
an important date for any company that has many stockholders, including those
that trade on exchanges, as it makes reconciliation of who is to be paid the
dividend easier. Existing holders of the stock will receive the dividend even if
they now sell the stock, whereas anyone who now buys the stock will not
receive the dividend.

The payment date is the day when the dividend checks will actually be mailed
to the shareholders of a company or credited to brokerage accounts.

Dividend-reinvestment plans: Some companies have dividend reinvestment

plan, or DRIPs. These plans allow shareholders to use dividends to
systematically buy small amounts of stock, usually with no commission and
sometimes at a slight discount. In some cases the shareholder might not need to
pay taxes on these re-invested dividends, but in most cases they do.

DIVIDEND POLICY: Dividend policies are the regulations and guidelines

that companies develop and implement as the means of arranging to make
dividend payments to shareholders. Establishing a specific dividend policy is to
the advantage of both the company and the shareholder. In order to make sure
the policy is workable, a company should develop a viable policy and then run
this policy through a number of test scenarios in order to determine what
impact the dividend policy would have on the operation of the business.

OBJECTIVES OF DIVIDEND POLICIES: Dividend policy has a effect of

dividing its net earnings into two parts: retained earnings and dividends. The retained
earnings provide funds to finance the firm’s long-term growth. Dividends are paid in
cash. A firm, which intends to pay dividends, will have to use external source of
financing like issue of debt and equity. Thus dividend policy of a firm has its effect on
both the long term financing and wealth of shareholders.

Firms need for funds: - When dividend decision is treated as financing decision, the
net earnings are considered as a source of long-term funds. The firm grows at a faster
rate when it accepts highly profitable investment projects. External equity could be
raised to finance investment but retained earning are preferred because unlike external
equity they do not involve any flotation cost. The distribution of cash dividends
causes a reduction in internal funds available to finance the profitable investment
opportunities and consequently, either constrain the growth or require the firm to find
other costly source of financing. Thus the firm may retain their earning as a part of
long term financing decision. The dividends will be paid to shareholders when a firm
cannot profitably reinvest earnings. With this approach, dividend decision is viewed
merely as a residual decision.

Shareholders need for income:- Because of market imperfection and uncertainty,

shareholders may prefer the near dividends to the future dividends and capital gains.
Thus, the payment of dividends may significantly the market price of share. Higher
dividends may significantly increase the value of share and low dividends may reduce
the value. It is believed by some that in order to maximize the wealth under
uncertainty, the firm must pay enough dividends to satisfy investors. Investors in high
tax brackets, on the other hand, may prefer to receive capital gains rather than
dividends. Their wealth will be maximized if firm retained earnings rather than
distributing them. Thus there should be proper balance between these two approaches.

Management should develop a dividend policy, which divides the net earnings into
dividends and retained earning in an optimum way to achieve the objective of
maximizing the wealth of shareholders.

PRACTICAL CONSIDERATION IN DIVIDEND POLICY:-

• Firms investment opportunities and financial needs.

• Shareholders expectations.

• Constrains on paying dividends

• Stability of dividends

• Forms of dividends

FIRMS INVESTMENT OPPORTUNITIES AND FINANCIAL NEEDS:-

Firms form dividend policy to have maximum financial flexibility and avoid
financial frictions and costs of raising external funds. Growth firms have large
number of investment opportunities requiring substantial amount of funds. Hence
they prefer retention of earning over payment of dividend. For matured firms,
investment opportunities often occur infrequently. These firms may distribute
most of their earnings. The retained earnings when they do not have investment
opportunities, may be invested in short term securities yielding nominal returns.

Retained earning are used as a source of internal financing only when a company
has profitable investment opportunities. If shareholders themselves have better
investment opportunities, the earnings should be distributed to them so that they
may be able to maximize their wealth. When the company has an internal rate of
return greater than the return required by shareholders, it would be to the
advantage of shareholders to allow the investment of earning by the company.
When the company does not have highly profitable opportunities and earns a rate
on investment, which is lower than the rate required by shareholders, it is not in
the interest of shareholders to retain earnings.

Companies prefer to retain earning because issuing new share capital is

inconvenient as well as involve floatation costs. If company raises debt the
financial obligation and the risk will increase. Thus directors neither follow a
practice of paying 100% dividends nor a practice of retaining 100% earning.

A company has target payout ratio. In the absence of profitable investment

opportunities, it can pay some extra dividends but still retaining some earning for
continued existence of the enterprise. Though shareholders are owners of the
company and directors should follow a policy desired by them. Shareholders are
the residual claimants of the earning of the company. Directors must retain some
earning, whether or not profitable investment opportunity exists, to maintain the
company as sound and solvent enterprise and to have financial flexibility.

Depending on the needs to finance their long-term investment opportunities,

companies follow different dividend policies. Mature companies that have fewer
investment opportunities may generally have high payout ratio. The share prices
of such companies are very sensitive to dividend changes. Growth companies
have plenty of investment opportunities and hence they may have low payout
ratios. They are continuously in need of funds to finance their fast growing fixed
assets. The distribution of funds reduces the funds of the company. Therefore
sometimes growth companies retain most of their earning and issue bond shares,
regularly or from time to time, to satisfy the dividend need of shareholder. These
companies would slowly increase the amount of dividends as the profitable
investment opportunities start fading.

SHAREHOLDERS EXPECTATIONS:- Directors decide the distribution of

earnings of a company. Shareholders are the legal owners of the company, and the
directors are appointed by them, are their agents. Therefore directors give due
importance to the expectations of shareholders in the matter of dividend decision.
Shareholders preference for dividends or capital gains may depend on their
economic status and the effect of tax on dividend and capital gains. In most
countries dividend income is taxed at a higher than the capital gains.

In closely held company, the body of the shareholders is small and homogeneous
and management usually knows the expectation of shareholders. Therefore, they
can easily adopt a dividend policy, which satisfies most of shareholders. If most of
shareholders are I high tax brackets and have a preference for capital gains to
current dividend incomes, the company can establish a dividend policy of paying
sufficient dividends and retaining the earnings within the company.

In widely held companies, the number of shareholders is very large, they are
dispersed and may have diverse desires regarding dividends and capital gains. So
it is not possible to follow a dividend policy, which equally satisfies all
shareholders. They may follow a dividend policy, which serves the purpose of
dominating group, but does not completely neglect the desires of others. In this
shareholders are widely divided into four groups: small, retired, wealthy and
institutional shareholders.

Small shareholders are not the frequent purchasers of the shares. They hold small
number of shares. They purchase shares only when their saving permits. Retired
and old persons generally invest in shares to get a regular income. These select
companies that have a history of paying regular and liberal dividends. Retired
person having some source of income may be interested in capital gains as well.
Wealthy investors are concerned about the dividend policy followed by the
company. They have definite investment policy of increasing their wealth and
minimizing taxes. They prefer a dividend policy of retaining earning and
distributing bonus shares. The wealthy shareholders are dominating in a company
and are able to influence the composition of board of directors by their significant
voting rights. Institutional investors purchase a large block of shares to hold
them for relatively longer period of time. They are not concerned about with
personal income tax but with profitable investments. Most of them avoid
speculative issues, seek diversification in their investment portfolio and favour a
policy of regular cash dividend payments.

The interests of various shareholders groups are in conflict. So board of directors

should consider two points. First, the board of directors should adopt a dividend
policy, which gives some consideration to the each groups comprising a
substantial proportion of shareholders. Second, a dividend policy once formed
should be continued as long as it does not interferes with the financing need of the
company. Investors who consider the dividend policy in accord with their
investment requirement. If a company suddenly changes its dividend policy, it
may work to the detriment of these shareholders. Thus an established dividend
policy must be changed slowly and after having analysed its probable effect on
existing shareholders.

CONSTRAINS ON PAYING DIVIDENDS:- The company’s decision

regarding the amount of earning to be distributed as dividends depend on legal
and financial constrains.

Legal restrictions The dividend policy of a firm has to evolve within the legal
framework and restrictions. The directors are not legally compelled to declare
dividends. The legal rules act as boundaries within which a company can operate
in terms of paying dividends. Acting within these boundaries, a company will
have to consider many financial variables and constrains in deciding the amount
of earnings to be distributed as dividends.

Liquidity:- the cash position of firm is an important consideration in paying

dividends; the greater the cash position and overall liquidity of a company, the
greater will be its ability to pay dividends. A mature company is generally liquid
and is able to pay a large amount of dividends. Growing firms face a problem of
liquidity. Even if they make good profits, they continuously need fund for
financing growing fixed assets and working capital so they follow conservative
dividend policy

Financing condition and borrowing capacity: A high degree of financial

leverage makes a company quite vulnerable to changes in earnings, and also it
becomes quite difficult to raise funds externally for financing its growth. Thus
financially leveraged company is expected to retain more to strengthen its equity
base. However a company with steady growing earning and without much
investment opportunities may follow a high dividend payment policy. Financial
flexibility includes the firms ability to access external funds at a later date. The
firm may loose the flexibility and capacity of raising external funds to finance
growth opportunities in future.

Access to the capital market: easy accessibility to the capital market provides
flexibility to management in paying dividends as well as in meeting the corporate
obligations. The greater is the ability of firm to raise funds in the capital markets,
greater will be its ability to pay dividends even if it is not liquid.

Restrictions in loan agreement: lenders may generally put restrictions on

dividend payment to protect their interest when the firm is experiencing low
liquidity. When these restrictions are put, the company is forced to retain earning
and have low payout.

Inflation: When prices rise, funds equal to depreciation set aside would not be
adequate to replace assets or to maintain the capital intact. To maintain the capital
intact and preserve their earning power, firms may avoid paying dividends. Some
companies may follow paying more dividends during high inflation in order to
protect the shareholders from the erosion of real value dividends.

Control: when company pays large dividends it has to issue new shares to raise
funds for investment purposes. The control of existing shareholders will be diluted
if they cannot buy additional shares. Under these circumstances, the payment of
dividends may be withheld and earnings may be retained to finance firms
investment opportunities.

STABILITY OF DIVIDENDS:- means regularity in paying some dividends

annually. Three forms of such stability may be distinguished:

• Constant dividend per share or dividend rate

• Constant payout

• Constant dividend per share plus extra dividend

Constant dividend per share or dividend rate: In india companies

announce dividend as a percent of the paid up capital per share. This can
be converted into dividend per share. When the company reaches a new
levels of earnings and expects to maintain them, the annual dividend per
share or dividend rate must be increased. It is easy to follow this policy
when earnings are stable. In fluctuations it is difficult to maintain such
policy. In practice when a company retains earnings in good years, it
earmarks its surplus as dividend equalization reserve. These are invested
in current assets so that they may be easily converted into cash when
needed. Those investors who have dividends as the only source of their
income may prefer constant dividend policy. This helps in stabilizing the
market price of share.

Constant payout: The ratio of divident to earning is known as payout

ratio. Some companies pay a fixed percentage of net earning every year.
With this policy the amount of dividends will fluctuate in direct
proportion to earning. This policy is related to a company’s ability to pay
dividends. If the company incurs losses then no dividends shall be paid
regardless of desires of shareholders. This policy does not put any
pressure on company’s liquidity since dividends are distributed only when
company has profits.

Constant dividend per share plus extra dividend: companies with

fluctuating earnings, the policy to pay minimum dividend per share is
desirable. Paying extra dividend in period of prosperity. This policy
enable a company to pay a constant amount of dividend regularly without
a default and allows a great deal of flexibility.

Merits of stability of dividends: several advantages are:-

 • Resolution of investors uncertainity.

• Investors desire for current income.

• Institutional investors requirement.

• Raising additional finances.

Danger of stability of dividends: the greatest danger in adopting a stable dividend

policy is that once it has established it cannot be changed without seriously affecting
investors attitude and the financial standing of the company.

FORMS OF DIVIDEND: different forms of dividend are:

• cash dividend

• bonus shares (stock dividend)

Cash dividend:- companies mostly pay dividends in cash. A company should have
enough cash in its account when cash dividends are declared. If it does not have
enough cash balance, arrangements should be made to borrow funds. While following
stable dividend policy it should prepare a cash budget for the coming period. It is
relatively difficult to make cash planning in anticipation of dividend needs when an
unstable policy is followed. Both the total assets and net worth of company are
reduced when the cash dividend is distributed. The market price of share drops in
most cases by amount of cash dividend distributed.

Bonus shares:- Issue of bonus shares is the distribution of shares free of cost to the
existing shareholders. In India bonus shares are issued in addition to cash dividend.
Issuing bonus shares increases the number of outstanding shares of the company. The
bonus shares are distributed proportionately to the existing shareholder. Thus there is
no dilution of ownership. The declaration of the bonus shares will increase the paid up
share capital and reduce the reserve and surplus. The total net worth is not affected by
the bonus issue. In fact the bonus issue represents a recapitalization of reserves and
surplus. It is merely an accounting transfer from reserves and surplus to paid up
capital.

Advantages of bonus shares:- bonus shares do not affect the wealth of shareholders.
ADVANTAGES OF BONUS SHARE TO SHAREHOLDERS:-

Tax benefit- When a shareholder receives cash dividend from company, this is
included in his ordinary income and taxed at ordinary income tax rate. But the receipt
of bonus shares by shareholders is not taxable as income. Shareholder can sell the
new shares received and pay capital gain taxes, which are usually less than the income
taxes on the cash dividends.

Indication of higher future profits- the issue of bonus shares is normally interpreted
by shareholders as an indication of higher profitability. When the profits of company
do not rise, and it declares a bonus issue, the company will experience a dilution of
earnings as a result of additional shares outstanding. Thus bonus shares convey
information that may have favorable impact on value of shares.

Future dividends may increase- If the company has been following a policy of
paying fixed amount of dividend per share and continues it after declaration of bonus
issue, the total cash dividends of the shareholders will increase in the future.

Psychological value- declaration of bonus issue may have favorable psychological

effect on shareholders. They also associate with the prosperity of the company.
Because of these positive aspects of the bonus issue, the market usually receives it
positively. This tends to increase the market interest in the company’s shares. Thus
supporting or raising its market price.

ADVANTAGES OF BONUS SHARES TO COMPANY:-

Conservation of cash- The declaration of bonus issue allows the company to declare
a dividend without using up cash that may be needed to finance the profitable
investment opportunities within the company. The company is thus able retain
earnings and at the same time satisfy the desires of shareholders to receive dividend.
The use of bonus issue represents a compromise, which enables directors to achieve
both these objectives of dividend policy. The company could retain earnings without
declaring bonus share issue.

Only means to pay dividend under financial difficulty and contractual

restrictions- Under the situations of financial stringency or contractual constrain in
paying cash dividend, the bonus issue is meant to maintain the confidence of
shareholders in company.

LIMITATIONS OF BONUS SHARES:- bonus shares have following limitations:

• Shareholders wealth remain unaffected

• Costly to administer

• Problem of adjusting EPS and P/E ratio

The declaration of bonus shares is a method of capitalizing the past earning of the
shareholders. Thus it is a formal way of recognizing earning which the shareholders
already own. It merely divides the ownership of the company into large number of
share certificates. The disadvantage of bonus issues from the company’s point of view
is that they are more costly to administer than cash dividend. The bonus issue can be
disadvantageous if the company declares periodic small bonus shares.

Conditions for the issue of bonus shares- The maximum bonus share ratio is 1:1 i.e.
one bonus share for one fully paid up share held by existing shareholders. However
two criteria are required to be satisfied within the limit of the maximum ratio. They
are:-

• Residual ratio criterion

• Profitability criterion

Residual ratio criterion- It requires that reserve remaining after the amount
capitalized for bonus issue should be at least equal to 40% of the increased paid-up
capital. Redemption reserve and capital reserve on account of assets revaluation are
excluded while investment allowance reserve is included in computing the minimum
residual reserve.

(Pre bonus reserve)- Pre bonus paid up capital * Bonus ratio >= 0.4(1+Bonus ratio)*
Pre bonus paid up capital

Profitability criterion- It requires that 30 per cent of the previous 3 years average pre
tax profit (PBT) should be at least equal to 10% of the increased paid up capital.

0.3 * 3 yrs average PBT >= 0.1 (1+Bonus ratio) * Pre bonus paid up capital
SHARE SPLIT:- Share split is a method to increase the number of outstanding
shares through a proportional reduction in par value of the share. A share split affects
only the par value and the number of outstanding shares; the shareholders total funds
remain unaltered.

Reasons of share split:-

• To make trading in shares attractive

• To signal the possibility of higher profits in the future

• To give higher dividends to shareholders

To make shares attractive- The main purpose of a stock split is to reduce the market
price of share in order to make it attractive to investors. With the reduction in market
price of share, the shares of company are placed in a more popular trading range.
Thus the reduction in the market price caused by share split motivates more investors
particularly those with small savings to purchase the shares. This helps in increasing
the marketability and liquidity of market shares.

Indication of higher future profits- the share splits are used by the company
management to communicate to investors that the company is expected to earn higher
profits in future. The market price of high growth firm shares increases very fast.

Increased dividends- when the share is split, seldom does a company reduce or
increase the cash dividend per share proportionately. However, the total dividends of
a shareholder increase after share split. The increased dividends may favourably
affect the after split market price of the share. It should be noted that the share split
per se has no effect on the market price of share.

REVERSE SPLIT:- Under a situation of falling price the company may want to
reduce the number of outstanding shares to prop up the market price per share. The
reduction of the number of outstanding shares by increasing per share value is known
as reverse split.

BUYBACK OF SHARES:- The buyback of shares is repurchase of its own shares by

a company. Until recently the buyback of shares by companies in India was
prohibited under section 77 of Indian Companies act. In India the following
conditions apply in case of buy back of shares:

• A company buying back its share will not issue fresh capital, except bonus
issue, for the next 12 months.

• The company will state the amount to be used for the buyback of share and
seek prior approval of shareholders.

• The buyback of shares can be affected only utilizing the free reserves, viz.,
reserves not specifically earmarked for some purpose.

• The company will not borrow funds to buyback shares.

• The shares brought under the buyback scheme will be extinguished and they
cannot be reissued.

Methods of shares buyback:- There are two methods of the share buyback in
India. First, a company can buy its shares through authorized brokers on the open
market. Second, the company can make a tender offer, which will specify the
purchase price, the total amount and the period within which the shares will be
brought back.

Effects of shares buyback:- It is believed that the buyback will be financially

beneficial to the company, the buying shareholders and the remaining
shareholders. This will permanently reduce the amount of equity capital and the
number of outstanding shares. If the company distributed surplus cash and it
maintains its operating efficiency, EPS will increase. The share price will increase
as P/E is expected to remain the same after the buyback.

Advantages of buyback:-

• RETURN OF SURPLUS CASH TO SHAREHOLDERS- The buying

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

• INCREASE IN SHARE VALUE:-When the company distributes the

surplus cash, its operating efficiency and P/E ratio remains intact. With
reduced number of shares, EPS increases and share price also increases.
 • INCREASE IN TEMPORARILY UNDERVALUED SHARE PRICE:-
Companies may buyback share at higher prices to move up the current
share prices.

• ACHIEVING THE TARGET CAPITAL STRUCTURE:- If a company

has high proportion of equity in its capital structure, it can reduce equity
capital by buying back its share.

• CONSOLIDATING CONTROL:- the promoters of company do not sell

their shares to the company rather make the buyback attractive for others.
Their proportionate ownership increases.

• TAX SAVING BY COMPANIES:-Dividends payments are taxable in the

hands of companies at 12.5%. They will avoid paying dividend taxes if
they compensate shareholders through the share buyback.

• PROTECTION AGAINST HOSTILE TAKEOVERS:- In hostile takeover,

a company may buyback its shares to reduce the availability and make
takeover difficult.

Drawbacks of the buyback:-

• Not an effective defense against takeover

• Shareholders do not like the buyback

• Loss to the remaining shareholders

• Signal of low growth opportunities