Factor affecting dividend policy

Answer 1

Dividend Decision

Dividend

Meaning: Dividend is that part of the profits of a company which is distributed amongst its shareholders.

Definition: According to ICAI, "Dividend is a distribution to shareholders out of profits or reserves available for this purpose."

Nature of Dividend Decision

The dividend decision of the firm is crucial for the finance manager because it determines:

1. the amount of profit to be distributed among the shareholders, and

2. the amount of profit to be retained in the firm.

There is a reciprocal relationship between cash dividends and retained earnings.

While taking the dividend decision the management take into account the effect of the decision on the maximization of shareholders' wealth.

Maximizing the market value of shares is the objective.

Dividend pay out or retention is guided by this objective.

Dividend Policy

Factors Affecting Dividend Policy:

1. External Factors

2. Internal Factors

External Factors Affecting Dividend Policy

1. General State of Economy:

• In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks.
• In the period of depression the management may also retain a large part of its earnings to preserve the firm's liquidity position.
• In periods of prosperity the management may not be liberal in dividend payments because of availability of larger profitable investment opportunities.
• In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines.

2. State of Capital Market:

• Favourable Market: liberal dividend policy.
• Unfavourable market: Conservative dividend policy.

3. Legal Restrictions:

Companies Act has laid down various restrictions regarding the declaration of dividend:

• Dividends can only be paid out of:
• ** Current or past profits of the company.
  • Money provided by the State/ Central Government in pursuance of the guarantee given by the Government.
• Payment of dividend out of capital is illegal.
• A company cannot declare dividends unless:
• ** It has provided for present as well as all arrears of depreciation.
  • Certain percentage of net profits has been transferred to the reserve of the company.
• Past accumulated profits can be used for declaration of dividends only as per the rules framed by the Central Government

4. Contractual Restrictions:

Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems)

Example:

A loan agreement that the firm shall not declare any dividend so long as the liquidity ratio is less than 1:1.

The firm will not pay dividend more than 20% so long as it does not clear the loan.

Internal Factors affecting dividend decisions

1. Desire of the Shareholders:

Though the directors decide the rate of dividend, it is always at the interest of the shareholders.

Shareholders expect two types of returns:

[i] Capital Gains: i.e., an increase in the market value of shares.

[ii] Dividends: regular return on their investment.

Cautious investors look for dividends because,

[i] It reduces uncertainty (capital gains are uncertain).

[ii] Indication of financial strength of the company.

[iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses.

2. Financial Needs of the Company:

If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings.

3. Nature of earnings:

A company which has stable earnings can afford to have an higher divided payout ratio

4. Desire to retain the control of management:

Additional public issue of share will dilute the control of management.

5. Liquidity position:

Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends

Stability of Dividends

The term stability of dividends means consistency in the payment of dividends. It refers to regular payment of a certain minimum amount as dividend year after year.

Even if the company's earnings fluctuate from year to year, its dividend should not. This is because the shareholders generally value stable dividends more than fluctuating ones.

Stable dividend can be in the form of:

1. Constant dividend per share

2. Constant percentage

3. Stable rupee dividend plus extra dividend

Significance of Stability of Dividend

1. Desire for current income

2. Sign of financial stability of the company

3. Requirement of institutional investors

4. Investors confidence in the company

Danger of Stable Dividend Policy

Stable dividend policy may sometimes prove dangerous. Once a stable dividend policy is adopted by a company, any adverse change in it may result in serious damage regarding the financial standing of the company in the mind of the investors.

Forms of Dividend

1. Cash Dividend:

The normal practice is to pay dividends in cash.

The payment of dividends in cash results in cash outflow from the firm. Therefore the firm should have adequate cash resources at its disposal before declaring cash dividend.

2. Stock Dividend:

The company issues additional shares to the existing shareholders in proportion to their holdings of equity share capital of the company.

Stock dividend is popularly termed as 'issue of bonus shares.'

This is next to cash dividend in respect of its popularity.

3. Bond Dividend:

In case the company does not have sufficient funds to pay dividends in cash it may issue bonds for the amount due to shareholders.

The main purpose of bond dividend is postponement of payment of immediate dividend in cash. The bond holders get regular interest on their bonds besides payment of the bond money on the due date.

[Bond dividend is not popular in India]

4. Property Dividend:

This is a case when the company pays dividend in the form of assets other than cash. This may be in the form of certain assets which are not required by the company or in the form of company's products.

[This type of dividend is not popular in India]

Bonus Shares

When the additional shares are allotted to the existing shareholders without receiving any additional payment from them, is known as issue of bonus shares.

Bonus shares are allotted by capitalizing the reserves and surplus.

Issue of bonus shares results in the conversion of the company's profits into share capital. Therefore it is termed as capitalization of company's profits.

Since such shares are issued to the equity shareholders in proportion to their holdings of equity share capital of the company, a shareholder continues to retain his/ her proportionate ownership of the company.

Issue of bonus shares does not affect the total capital structure of the company. It is simply a capitalization of that portion of shareholders' equity which is represented by reserves and surpluses.

It also does not affect the total earnings of the shareholders