Financial Management III Semester B.

Com

DIVIDEND POLICY AND DECISIONS

Dividend refers that part of profit of a company which is distributed by the company
among its shareholders. Dividends may be brought into different categories in accordance
with the forms in which they are paid. The following are the various forms of dividends.
1. Cash Dividend
Dividend is usually paid in cash. When dividend is paid in cash, it is known as cash
dividend, But the payment of dividends in cash involves outflow of funds from the firm.
Thus a firm should have enough cash in its bank account when cash dividends are
declared. When cash dividend is paid, both the cash account and the reserves account of the
firm will be curtailed. Hence, both the net worth and the total assets of the firm are reduced
when the cash dividend is distributed. Moreover, the market price of the share comes down
in most cases by the amount of the cash dividend distributed.
2. Stock Dividend [Bonus
[Bonus Shares]
Shares]
When a firm issues its own shares to the existing shareholders in lieu of or in addition to
cash dividend, it is called stock dividend or scrip dividend. In India, the payment of stock
dividend is popularly termed as “issue of bonus shares”. The issue of bonus shares has the
effect of increasing the number of outstanding shares of the firm. The shares are distributed
proportionately. Hence, a shareholder retains his proportionate ownership of the firm. The
declaration of the bonus shares will enhance the paid-up share capital and curtail the
reserve and surplus (retained earnings) of the firm. Bonus issue is merely an accounting
transfer from reserves and surplus to paid-up capital.
Advantages of bonus shares
a. It conserves the company’s liquidity as no cash leaves the company.
b. The shareholder who receives a dividend can be converted into cash as and when he
wants through selling the additional shares,
c. It broadens the capital base and enhances image of the company. –
d. It helps to decline the market price of the shares, rendering the shares more
marketable.
e. It is an indication to the prospective investors about the financial soundness of the
company.
f. It is one of the best ways of bringing the paid up capital of the company in line with
actual capital employed in the business,
g. It is an inexpensive method of raising capital by which the cash resources of the
company are preserved.
h. It absolves the liability of the shareholders when bonus is applied for converting
partly paid up shares into fully paid-up.
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Disadvantages of bonus shares

a. After bonus issue, there is a sharp fall in the future market price of the share.
b. The rate of dividend in future will come down.
c. Lengthy legal procedures and approvals are involved in the issue of bonus shares.
d. When the conversion of partly paid-up shares into fully paid-up shares is made the
company foregoes cash equivalent to the amount of bonus applied for this purpose.
SEBI Guidelines on Bonus Issues
The company shall, while issuing bonus shares ensure the following guidelines issued by
the Securities Exchange Board of India (SEBI) on 11th June, 1992.
1. The bonus issue is made out of free reserves built out of the genuine profits or share
premium collected in cash only.
2. Reserves created by revaluation of fixed assets are not capitalised.
3. The development rebate reserve or the investment allowance reserve is considered as
free reserve in order to calculate residual reserve test. –
4. The residual reserves after the proposed capitalisation shall not be less than 40 % of
the increased paid-up capital.
5. All contingent liabilities disclosed in the audited accounts which have the bearing on
the net profits shall be considered for computing residual reserves.
6. The declaration of bonus issue, in lieu of dividend, is not made.
7. The bonus issue is not made unless the partly-paid sh4es, if any existing, are made
fully paid-up.
8. No bonus issue shall be made within 12 months of any public/right issue.
9. No bonus issue shall be made which will dilute the value or rights of the holders of
debentures, convertible fully or partly.
10. Consequent to the issue of bonus shares if the subscribed and paid-up capital
exceeds the authorised share capital, a resolution shall be passed by the company at
its general body meeting for enhancing the authorised capital.
11. There should be a provision in the Articles of Association of the company for
capitalisation of reserves, etc., and if not, the company shall pass a resolution at its
general body meeting making provisions in the Articles for capitalisation.
12. A company which announces its issue after the approval of the Board of directors
should implement the proposals within a period of six months from the date of such
approval and shall not have option of changing the decision.
3. Bond Dividend
A firm may issue bonds for the amounts due to shareholders by way of dividends if it
does not have enough funds to pay dividend in cash. The purpose behind such an issue is
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the postponement of payment of immediate dividend in cash. Here the bondholders get
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Financial Management III Semester B.Com

regular interest on their bonds in addition to the bond money on the due date. In India,
bond dividend is not popular.
4. Property Dividend
Property dividend is also not popular in India. When a firm pays dividend in the form of
assets other than cash, it is called property dividend. The payment of such a dividend may
be in the form of a firm’s product or in the form of certain assets which are not required by
the firm.
5. Interim Dividend
A dividend which is declared before the declaration of the final dividend is called the
interim dividend. In other words, interim dividend is a dividend which is declared between
two annual general meetings. If the profits of the company appear to be justified for the
payment of interim dividend, the Board of directors may from time to time pay to the
members such dividends. While deciding to declare an interim dividend, the directors
should take into consideration the future prospects of the profits, cash resources etc., of the
company.
DIVIDEND POLICY
Dividend policy is the policy concerning the amount of profits to be distributed as dividend.
Usually companies through their Board of Directors evolve a pattern of dividend payment
which has a bearing on future action. The power to recommend/declare dividends vests
completely in the board of directors of the company.
Factors Affecting Dividend Policy
The factors affecting dividend policy are divided into:
I. External Factors
The following are the various external factors affecting dividend policy of the company:
1. General State of Economy: The management’s decision to retain or distribute earnings of
the firm mainly relates to the general state of economy. However, the management may
prefer to retain the whole or part of the earnings with a view to building up reserves during
Uncertain economic and business conditions, depression, prosperity and inflation
2. State of Capital Market:
Market A firm can follow a liberal dividend policy if it has an easy access
to the capital market on account of its financial strength or favourable conditions prevailing
in the capital market. However, a firm is likely to adopt a more conservative dividend policy
if it has no easy access to capital market because of its weak financial position or
unfavorable conditions in the capital market.
3. Legal Restrictions: A firm may also be legally restricted from declaring and paying of
dividends. The Companies Act of 1956 contains several restrictions relating to the
declaration and payments of dividends.
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The following are some of the legal restrictions imposed on dividend declaration of
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companies.

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a. A company is entitled to pay dividend only out of its

a. current profits,
b. past accumulated profits
c. money provided by the Central or State Governments for the dividend
payments in pursuance of the guarantee given by the Government. However,
the dividend payment out of capital is illegal.
b. A company is not entitled to pay dividend unless it has provided for current and all
arrears of depreciation, and a certain percentage of net profits of that year has been
transferred to the reserves of the company.
c. A company can use the past accumulated profits for the declaration of dividends
only in accordance with the rules framed by the Central Government in this behalf.
d. The Income tax Act also prescribes certain restrictions about the payment of
dividend. The management should consider all the legal restrictions before taking
the dividend decision.
4. Contractual Restrictions:
Restrictions: Restrictions which are imposed by the lenders of the firm are
called contractual restrictions. The lenders of the firm lay down restrictions on dividend
payment to protect their interest particularly during the period when the firm is
experiencing liquidity or profitability crisis.
5. Tax Policy: The tax policy followed by the Central Government also affects the dividend
policy of the firm. Sometimes the government provides tax incentives to those companies
which retain most of their earnings. In such a situation, the management is inclined to
retain a larger amount of the firm’s earnings.
Internal Factors
Various internal factors which affect the dividend policies of the firm are as follows:
1. Desire of the Shareholders: Shareholders expect returns from their investment in a
firm in the form of both capital gains and dividends. Capital gain relates to the profit as a
result of the sale of capital investment, i.e., equity shares in the case of shareholders.
Dividends are the regular return expected by the shareholders on their investment in a
firm. The desire of the shareholders to get dividends takes priority over the desire to earn
capital gains on account of the following reasons.
2. Future requirements:
requirements: The prudent management should give more weightage to the
financial needs of the company than the desire of the shareholders. While retained earnings
help for the further growth of the firm, the payment of dividend will adversely affect both
the owner’s wealth and long term growth of the firm. Thus a firm requires an optimum
dividend policy which should maximise the firm’s wealth and provide enough funds for the
growth in future.
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3. Nature of Earnings: A firm whose income is stable can afford to have a higher
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dividend payout ratio than a firm which does not have such stability in its earnings.

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Financial Management III Semester B.Com

4. Liquidity Position: The payment of dividends usually involves cash outflow. Thus
sometimes, a firm which has adequate earnings may not have sufficient cash to pay
dividends. It is, therefore, the duty of the management to see the liquidity aspect of the firm
before and after payment of dividends wh1’e taking the dividend decision. The management
should keep in mind that, in no case can the liquidity ratio be less than 1:1 after the
payment of dividends.
5.Desire of Control: The desires of the shareholders or management should also
influence the dividend policy of the firm. If a firm issues additional equity shares for raising
funds, it will dilute control which is detrimental to the existing equity shareholders. Thus in
the case of strong desire for control, the management prefers a smaller dividend payout
ratio and hence low rate of dividend.
6. Age of the company: a newly established concern has to limit payment of dividend
and retain substantial part of earnings for financing its future growth and development,
while older companies can afford to pay liberal dividends because of sufficient reserves.
Types of dividend policy
1. Regular dividend policy
Payment of dividend at the usual rate is termed as regular dividend. Regular dividends can
be maintained by companies of long standing and stable earnings. The main advantage of
regular dividend policy is;
a. Establishes a profitable record of the company
b. Creates confidence among shareholders
c. Stabilizes market price of shares
d. Meets the day to day living expenses of the ordinary shareholders
e. Aids long term financing.
2. Irregular dividend policy
Some companies follow irregular dividend policy on account of uncertainty of earnings,
unsuccessful business operations, lack of liquid resources, etc
3. No dividend policy
A company may follow a policy of paying no dividends presently because of unfavourable
working capital position or requirement of funds for future expansion and growth.
4. Stable dividend policy
Stable dividends relate to the consistency or lack of variability in the streams of dividends
payments. It means a regular payment of a certain minimum amount as dividend or
earnings/profits may fluctuate from year to year but not the dividend. The stability of
dividends can be in any of the following three forms:
a. Constant Dividend per Share
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Under this policy, the firm pays a certain fixed amount per share by way of
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dividends. This fixed sum per share is paid year after year irrespective of the level of

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Financial Management III Semester B.Com

earnings of the firm. When the earning increases, the amount of dividend also increases if
the firm can maintain the new level in future. Moreover, there will not be any change in the
payment of dividend in the cast of temporary increase in earnings.

b. Constant Percentage
Under this policy, a certain percentage of net earnings/profits is paid year after year
as dividend to the shareholders, In the case of constant payout ratio policy the amount of
dividend fluctuates in direct proportion to the earnings of the firm. As per this policy when
the earnings of a firm decrease, the dividend will naturally be low.
c. Constant Dividend per Share plus Extra Dividend
Under this policy, fixed dividend per share is paid to the shareholders. But during
market prosperity, additional or extra dividend is paid over and above the regular dividend.
This extra dividend is waived immediately on the return of normal conditions.
The most appropriate policy is the constant dividend per share. This is due to the fact
that most investors expect a fixed rate of return from their investment which should
gradually go up over a period of time. But in the case of the constant percentage of net
earnings policy, the return to the shareholders varies in accordance with the earnings. The
management may be in favour of constant percentage policy as it correlates the amount of
dividend to the firm’s ability to pay dividend. However, the shareholders are against it as it
involves uncertainties. But the constant dividend per share plus extra dividend policy is not
preferred by the shareholders because of its general uncertainty about the extra dividend.
Advantages of Stability of Dividend
A stable dividend policy is advantageous from the point of view of shareholders and the
firm on account of the following reasons.
1. Expectation of Current Income: Many investors such as retired persons, widows, etc.,
consider dividend as a source of income to meet their current living expenses. Such
expenses are almost fixed in nature and hence a stable dividend policy should have least
inconvenience to these investors.
2. Perception of Stability: When a firm declares regular dividend, the shareholders
usually accept it as a sign of normal operation. But, a decline in the rate of dividend will be
considered as a token of expected trouble in the future. Thus most of the shareholders
would like to dispose their shares without further checking. As a result, the market value of
the firm’s shares will come down. Such uncertainties can be avoided if the firm follows a
stable dividend policy.
3. Requirements of Institutional
Institutional Investors: Usually, the shares of the companies are
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acquired both by individuals and institutions. But every firm would like to sell its shares to
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financial institutions as they are the largest buyers of shares in the corporate sector in our

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Financial Management III Semester B.Com

country. As such, a stable dividend policy is a prerequisite to attract the investible funds of
these institutions.
4. Raising Additional Finance: For raising additional funds from external sources, a
stable dividend policy is beneficial to the firm. The investors develop confidence in such a
firm for further issue of shares.
DIVIDEND THEORIES
Dividend decision is one of the unique areas of financial management as the firm is to
choose one between the two alternatives, viz, (i) distribute the profits to the shareholders as
dividend, and (ii) retain profits in the business (i.e., ploughing back of profit). Thus it is
required to consider which alternative use is consistent with the object of wealth
maximization or there is a relationship between dividends and value of the firm which
should be carefully considered before any dividend decision. There are conflicting theories
regarding impact of dividend decision on the valuation of a firm. However, the view points
of these two schools of thought may be brought under the following two groups:
1. Relevance Concept of Dividend
2. Irrelevance Concept of Dividend
1. Relevance Concept of Dividend
Myron Gordon, James Walter and others are associated with the relevance concepts of
dividend. According to them, dividend policy of a firm has a direct effect on the position of
a firm in a stock market. This is mainly due to the fact that dividends actually communicate
information relating to the profit earning capacity of a firm to the investors. There are two
notable theories, viz, (a) Gordon’s Model, and (b) Walter’s Model explaining this concept.
GORDON’S MODEL (DIVIDEND GROWTH VALUATION MODEL)
Myron Gordon assumes a constant level of growth in dividends in perpetuity. According to
him, the dividends of most companies are expected to grow and evaluation of value of
shares based on dividend growth is often used in valuation.
Assumptions of Gordon’s model
1. Retained earnings represent the only source of financing.
2. Rate of return is constant.
3. The firm has perpetual or long life.
4. Cost of capital remains constant and is greater than growth rate.
5. Growth rate of the firm is the product of retention ratio and its rate of return.
6. Tax does not exist.
This model implies that when the rate of return is more than the cost of capital, the
price per share goes up as the dividend ratio comes down and in case the return is less than
cost of capital it is vice versa. However, the price per share remains constant in case the rate
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of return and discount rate are equal.

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WALTER’S VALUATION MODEL

Prof. James E. Walter suggests that dividend policy and investment policy of a firm are
interlinked and hence the dividend decision always affects the value of a firm. His
proposition clearly states the relationship between the firm’s internal rate of return[r] and
its cost of capital[k]. In short, in case the firm’s return on investment is more than the cost of
capital, it must retain its earnings and otherwise it should distribute its earnings to the
shareholders. Thus Walter’s model implies that:

The optimal payout ratio for a growth firm [r >k] is nil.
nil A firm is said to be a growth
firm when it has adequate profitable investment opportunities and its rate of
return[r] is more than cost of capital[k].

The optimal payout ratio for a normal firm [r=k]is
[r=k]is irrelevant.
irrelevant A firm is said to be
normal when its dividend policy does not affect the market price of a share and rate
of return is equal to cost of capital.

The optimal payout ratio for a declining firm [r<
[r<k] is 100%. A firm is said to be a
declining firm when it does not have profitable investment opportunities to invest its
earnings and its rate of return is less than cost of capital.
Assumptions of Walter’s model
a. All financing is done through retained earnings and external sources of funds like
debt or new equity capital are not used.
b. The firm has an infinite life and is a going concern.
c. It assumes that the internal rate of return [r] and cost of capital [k] are constant.
d. All earnings are either distributed as dividend or invested internally at once.
e. There is no change in the key variables such as Earning per Share and Dividend per
Share.
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Criticisms of Walter’s Model

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1. Walter assumes that the financial needs of a firm are met only by retained earnings
and not by external financing. However, it is seldom true in real world situations.
2. Walter also assumes that the firm’s internal rate of return remains constant. This
assumption does not hold good. Because, when more investment proposals are taken,
[r] also generally comes down.
3. The model also assumes that the cost of capital remains constant. This assumption
does not hold good in the real world situation. Because, if the risk pattern of a firm
changes, there is a corresponding change in the cost of capital.
II.Irrelevance
II Irrelevance Concept of Dividend
1. RESIDUAL APPROACH
According to this approach dividend decision has no effect on the wealth of the
shareholders or the price of the shares. The basic desire of the investors is to earn higher
return on their investment. And they do not differentiate between dividend and retention of
profit by firms. If the firm is not in a position to find profitable investment opportunities, the
investors would prefer to receive the earnings in the form of dividends. Thus if a firm
should retain the earning of it has profitable investment opportunities otherwise it should
pay them as dividend
2. MODIGLIANI-
MODIGLIANI-MILLER [MM] HYPOTHESIS
The irrelevance concept of dividend is provided by Modigliani & Miller in a comprehensive
manner. They argue that a firm’s dividend policy has no effect on its value of assets. They
have also argued that the value of shares of a firm is determined by its earning potentiality
and investment policy and never by the pattern of income distribution. Thus the value of the
firm is unaffected by dividend policy, i.e., dividends are irrelevant to shareholders wealth.
Assumptions of MM Model
They build their arguments on the basis of the following assumptions:

Capital markets are perfect.

There are no personal or corporate income taxes.

The firm’s capital investment policy is independent of its dividend policy.

Investors behave rationally. They freely get information and there are no floatation
and transaction costs.

Dividend policy has no effect on the firm’s cost of equity.

Risk or uncertainty does not exist.
The crux of MM hypothesis is that firm’s value depends on its asset investment policy rather
than on how earnings are split between dividends and retained earnings. In accordance
with the M-M hypothesis, the market value of a share in the beginning of the period is
equal to the present value of dividends paid at the end of the period plus the market price of
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the share at the end of the period. Thus the market price of a share after dividend declared
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is computed by applying the following formula.

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Financial Management III Semester B.Com

Criticism of M-M Hypothesis

M-M hypothesis is subject to severe criticism by virtue of unrealistic nature of assumptions.
They are as follows:
a. Tax Differential: M-M hypothesis assumes that taxes do not exist. This assumption is far
from reality. In real life, the shareholders will have to pay tax. But there are different rates
of tax for capital gains and dividends, Thus the cost of internal financing is cheaper than
that of external financing. In fact, the shareholders are in favour of a dividend policy with
retention of earnings as against the payment of dividends by virtue of tax differential.
b. Existence of Floatation Costs: M-M also assumes that both the internal as well as the
external financing are equivalent and same. But in true sense, the external financing is
costlier than internal financing since the companies are required to pay floatation costs by
way of underwriting fees and brokers’ commission a and when the funds are raised
externally.
c. Transaction Costs: M-M also assumes that whether dividends are paid or not, the
shareholders wealth will be the same. This assumption is also far from facts. The
shareholders are required to pay brokerage fee, etc., whenever they want to dispose the
shares. Thus they prefer dividends to retain their earnings.
d. Discount Rate: M-M hypothesis assumes that the discount rate is the same whether a
company chooses internal or external financing. This is not correct. In case the shareholders
want to diversify their portfolios, they would like to distribute earnings which they may be
able to invest in such dividends in other companies. In such a case, the shareholders will
have a higher value of discount rate if internal financing is being used and vice-versa.
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