21 Dividend Policy

P.G. Padma Gowri

Dividend refers to that portion of a firm’s net earnings which are paid out to the shareholders (ordinary Shareholders. Here, we are discussing about the dividend paid out to the equity shareholders since they are entitled to the residual income of the firm. The dividend policy is of relevance since; the alternative to paying dividend to the shareholders is to retain the dividends with the company as retained earnings which can be used for future investment activities of the firm. Hence, usually the company makes a decision as to whether dividends need to be paid, if so how should be paid or if the profits be retained and in that case how much as to be retained with the company. Usually companies retain earnings when there are profitable investment opportunities to the firm, or choices of expanding the existing business are there. In that case, since the profits easier and simple source of finance, they decide to plough back the profits into the business itself. Shareholders also show interest in this decision since this ploughing of profits into the business increases the wealth of the company. The idea is to maximize the wealth of the shareholders at large. There is different school of thoughts regarding the retention or repayment of dividends to the shareholders. Some argue that dividend policy is a residual decision therefore it does not affect the value of the firm. There are others who argue that dividend decisions are relevant and therefore affect the value of the firm. However it is important for us to explore the various factors that affect the dividend policy of the firm.

Determinants of Dividend Policy

1.   Dividend Payout Ratio (D/P ratio)

This is one of the important determinants of the Dividend Policy. Dividend Payout ratio refers to the percentage share of the earnings that are distributed to the shareholders as dividend. Those portions of the earnings that are not paid to the shareholders are used by the company for their investment purposes. This portion is an important and easy source of long term financing of the firm. Once the company pays dividend to the firm, it implies cash outflow and there is no chance of further use to the firm. Hence, the dividend payout ratio, or determining the portion to be paid and retained by the firm is of significant importance since it decides the future source of financing to the firm. The selection of D/P ratio should keep this in mind whereby it selects that ratio which satisfies the investors as well as the investment objectives of the firm. This will help to maximize the wealth of the shareholders. Shareholders also look into the long term prospects of the firm and therefore accept low dividends today in anticipation of growth in earnings in future. They discount the future earnings at a higher rate due to the uncertainty in the future earnings and the postponement of current consumption. It is to be understood that, retained earnings are slightly costly source of financing since the shareholders expect more out their retained portion of earnings. If sufficient investment options are not available it is advisable of the company to pay dividends to the shareholders. This should not be considered as a residual outlay but should be taken as a provision for the future outlay of the firm. Based on the above, companies should carefully choose to adopt a judicial D/P ratio.

2.   Stability of Dividends

Though there is no legal obligation on part of a company to pay dividends regularly, it is preferred by the shareholders to receive a steady dividend as it reflects the performance of the company. Non-payment of dividend or irregular dividend payment does not go well with the shareholders. Shareholders favor a stable dividend as much as they prefer a stable D/P ratio.

Constant Dividend per share – This is one form of a dividend policy followed by companies where the company fix a constant amount as Dividend and pay it yearly to their shareholders. Despite increase or decrease in the earnings, the dividend is paid at a fixed rate every year. A fluctuation in the earnings does not affect the dividend policy of the firm. This does not mean that the dividend remains constant throughout, but they remain same for a few years and they are changed from time to time. This policy is most suitable for those firms whose earnings are fluctuating and who do not want to pass it on to their shareholders. So those type of companies choose a constant dividend per share to their shareholders.

Constant Payout ratio – In this kind of a policy, instead of fixing the amount of dividend as constant, firms fix a percentage of earnings as dividend payout ratio. This means that a certain percentage of earnings say 25% or 30% of earnings are paid as dividend and the remaining are retained with the company for future investments. In this way, the shareholders are assured with a certain percentage of earnings as dividends. With changes in the earnings, the shareholders receive earnings as a percentage of the same. This is a most acceptable policy as the shareholders are sure about the payment of dividend.

Stable Rupee dividend plus Extra dividend – The firm in this case pays a fixed amount as dividend plus some extra dividend based on the performance of the firm’s earnings. This way the shareholders are happy and they know that if the company is doing well, they will receive extra dividend over and above the stable rupee dividend.

The three types of policies have their own share of merits and demerits, however it is to be understood that shareholders to a certain extent prefer a stable dividend for the following reasons:

• Desire for current income – Some shareholders invests in anticipation of income to take care of their financial commitments. In that case, they will prefer current income to future capital gains.
• Dividends possess informational content regarding the performance of the company
• Large institutional investors prefer to invest only in companies that regularly pay dividend.

Therefore, taking these points into consideration, the dividend policy have to be formulated.

3.   Legal, Contractual and Internal Constraints and Restrictions

The dividend decisions are also affected by certain legal, contractual and internal requirements and constraints. There are certain statutory requirements, contractual agreements that affect the dividend policy of the firm. Let’s see one by one in detail:

Legal requirements: Sometimes the legal stipulations of the firm might specify conditions under which dividends need to pay to the shareholders. They are as follows:

1. Capital impairment rules – This suggest that companies cannot pay dividends from their existing capital. Dividends are to be paid only out the earnings. This protectsthe interest of the creditors and preference shareholders by keeping the capital base intact.
2. Net Profits – Dividends can be paid out the net profits of the year and the accumulated profits. At any point the dividend payment cannot exceed the value of net profits and accumulated profits.
3. Insolvency – When a company is insolvent, it is prohibited from paying dividends to its shareholders.

Contractual Requirements – Some contractual requirements by the company may stipulate the payment of dividend only after achieving after certain level of earnings or till the time of repayment of loans. This will prevent the payment of dividend to the shareholders till such conditions satisfy.

Internal constraints – Some internal constraints of the firm affect dividend policy.

Liquid Assets– Does the company have sufficient liquid assets for the payment of dividend. When companies are growing, or having redemption of loans etc, payment of dividends will affect their liquidity position

Growth prospects – When the firms have growth prospects in line for them, payments of dividends is likely to affect them. That prevents them from payment of dividends.

Financial requirements – Every firm requires funds, some funds required are large were as some requirements are large. When the need for funds is immediate, the easily available option is the earnings of the company. So they may decide to postpone the dividend payment and take care of their immediate need.

Availability of funds – If funds availability are sufficient for the company and enough to take care of their investment requirements, the companies are safe. It does not alter the dividend policy. Whereas in a case where, there is shortage of funds to meet requirements, the easy alternative is to postpone the dividend payment.

Earnings stability – Dividend policy can be stable in case of firms that have predictable or somewhat stable earnings. This affects the dividend policy to a very large extent.

Control – The dividend policy is largely affected by the control exercised by the shareholders. Usually companies follow stable dividend policy to have control of the shareholders.

4.   Owner’s Consideration

Sometimes the dividend policy is affected by the considerations of the owner of the firm also.

Tax status of the shareholders – The dividend policy of the firm is affected by the tax status of the shareholders. When the company has shareholders who are in large tax brackets, they would prefer more retention of earnings than payment of dividends. They would prefer capital gains as against dividends. Since tax on capital gains is lower than dividend income, investors would prefer to receive dividends to be retained with the company. In other situations where the company has investors in low income bracket, it becomes essential for the company to pay dividends who prefer receiving income now rather than a later date.

Opportunities – The decision to retain or distribute income would largely depend on a sole factor as to whether the income will grow in the hands of the company or with the investor. When the number of opportunities to grow or maximize wealth is in the hands of the firm, it is advisable for the firm to retain the earnings, as this will promise growth and gains in future for the shareholders. But in the absence of opportunities, it is wise for the company to pay the dividends, as in this case the shareholders will find useful investment opportunities for their income. So the higher or lower D/P ratio will depend on the extent of growth opportunities available for the firm in hand.

Dilution of Ownership – It is to be understood that a high D/P ratio may result in the dilution of control and earnings for the existing share holders. Whenever the company paid the earnings in full, it is mandated to issue new securities to take care of its financial requirements. The new issue brings in new stakeholders in business and therefore affects the control of the company. Hence, in order not to dilute the control of the firm, it may choose to exercise low D/P ratio and retain the control with the firm by following higher retentions. This will also lead to the reduction in the dilution of earnings.

Though many factors have been taken into consideration for the payment of dividend, the most critical factor to be considered is shareholders sentiments and feelings. In all cases, the shareholders requirement and need is to be given utmost importance because it is their contentment that will help in the future prospects of the company. Any dividend policy that gives a sense of security and satisfaction to the shareholders needs to be chosen.

5.    Capital Market Considerations

This is one of the significant factors that have to be kept in mind while formulating dividend policy of the firm. In case of companies that have a quick and easy access to capital market and that can easily mobilize capital, it is advised to follow liberal dividend policy. In case of small firms, that do not have easy access to capital markets it is better for them to retain their existing earnings for their future investment needs. Otherwise they have to follow the difficult and costly route of mobilizing capital from the capital market. Another important factor is the financial institutions. If certain firms are largely dependent on financial institutions for their fund requirements, they usually declare a minimum dividend so that they become a member of the eligible list of those institutions. It is mostly followed by financial institutions to not buy shares or lend to companies that do not declare dividend regularly. In order to satisfy this condition it becomes mandatory for companies to follow stable dividend policy.

6.   Inflation

Of the many factors that affect the dividend policy of the firm, inflation does play a significant factor. When prices are steadily rising, it becomes difficult for companies to manage their fund requirements by other internal sources alone. Whenever, there is shortfall in funds for the firm, the easy source of finance is from the internally generated earnings. So the companies opt for lower D/P ratio. However, this has another concern too, rise in prices reduces the disposable income among the shareholders. So they will look out for additional income in the form of dividends to take care of their financial requirements. At this situation both the company and the shareholders are at cross roads. Arriving at a judicial D/P ratio that takes care of the interest of both the company as well as the shareholders is of importance. Usually during periods of inflationary situation companies follow low D/P ratio.

Bonus shares

An important part of the dividend policy of a company is the issue of bonus shares and stock splits. In case of Bonus shares, it entails the issue of new shares on a pro-rata basis to the existing shareholders while the firm’s assets, earnings, the risk, investor’s percentage of ownership in the company remain unchanged. The bonus shares and stock splits make a change only in the number of outstanding shareholders in the firm. Bonus shares are issued to the existing shareholders and stock splits involve splitting or dividing the existing face value of the shares into smaller denominations.

The main rationale of issuing of bonus shares or stock splits is to bring down the price of shares to a more popular trading range. The trading base gets larger in this case. The increase in the number of shares will allow more active trading in the stock market for the shares. This will help in fair pricing of the share. Another major advantage is the informational content of such activities. Whenever a Bonus share issue or a Stock split is announced this is perceived as a positive feedback about the company. This spreads good news among the shareholders and gives hope about the future earnings of the company. This also enables the conservation of corporate cash. If bonus shares are an activity to conserve cash for profitable investment opportunities, the share prices will automatically tend to rise and the shareholders will benefit. But again, if it is concealing financial difficulties this will have a negative impact among the shareholders. Hence it should be considered that issue of bonus shares/stock splits improves the prospect of raising additional funds for the company.

References:

1. Khan M Y, Jain P K, ‘Financial Management-Text and Problems(3rd edition)’, Tata McGraw Hill Publishing Company Limited.

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