What is Dividend Policy

A dividend policy is a set of guidelines or rules that a company follows

when deciding how much of its profits to distribute to its shareholders as
dividends. In India, the dividend policy is determined by the Board of
Directors of the company, taking into account the company's financial
performance, future investments, capital requirements, and other factors.

Dividend policy Factors

A company’s dividend policy is a guideline for distributing dividends to its

shareholders. These guidelines include the parameters for sharing
profits, the frequency of dividend announcements and the shareholder
preference while distributing dividends. One important thing to keep in
mind while investing in such companies is that not all shareholders get
the same dividend.

Every listed company does not need to pay dividends to their

shareholders. For those that do payout dividends, there are a couples of
factors that serve as an indicator to investors of whether the company is
likely to pay dividends or not.

1. Profitability
A company will declare a dividend only if it has made a profit. The
company’s profits also determine the proportion of dividends distributed
among the shareholders. 

2. Dividend payment history 

Generally, a company with a history of paying dividends to its

shareholders keeps its dividend amount stable. These are dividend
stocks where most investors park their money to earn stable dividend
income. 

3. Growth plans and availability of funds

A business might retain its profits if it has plans to reinvest them to

expand its business. However, if the company's retained earnings are
enough to fund its expansion, it may decide to pay dividends. 

4. Dividend trends in the industry

To retain their shareholders, companies might match the dividend trends

that exist in their industry. 

Types of dividend

If a company has decided to pay dividends to its shareholders, the next

crucial decision it needs to make is the dividend payout ratio. The
dividend payout ratio measures how much dividend you can get for each
of the shares you hold. It is calculated as the annual dividend per share
divided by the EPS or Earnings Per Share. EPS is a figure that
describes the profit amount per share of the company.  

Companies also need to decide what form of dividend they will payout to
shareholders. There are four major types of dividends.

1. Stock dividends 

Dividends can be given in the form of granting additional shares to

existing shareholders. A company can issue less than one-fourth of its
previously issued stock in stock dividends. However, if the company is
providing additional shares in the form of a stock split, it can surpass this
limit.

2. Cash dividends

In cash dividends, the company pays a fixed amount per share to its
shareholders. For example, if the dividend rate is 5% and you have 100
shares of the company, your cash dividend value would be 5 x ₹100 =
₹500. Cash dividends are more popular than other forms of dividends in
India. 

3. Property dividends 

Sometimes, a company issues a non-financial dividend to its

shareholders such as property dividend. These dividends can include
giving shares of a subsidiary company (another company under a parent
brand) as dividends. The value of property dividend is considered
against the current market price of the asset. For example, Kaya is a
subsidiary of Marico. If Marico gives Kaya’s shares as dividends, they
will be called property dividends. 

4. Scrip dividends

A scrip dividend is a promissory note that a company issues to its

shareholders when it does not have enough dividends. It is a promissory
note indicating that the company will pay dividends to its shareholders
later. These dividends are usually cash dividends. 

Apart from these four types, a company might also pay liquidating
dividends to its shareholders when it is wrapping up its business to
return the capital invested by the shareholders.

Interim and final dividend

A company pays an interim dividend before its profits are declared

during its Annual General Meeting (AGM). Companies distribute interim
dividends from their retained earnings. A company's retained earnings
are the amount of profit left after paying direct and indirect costs and
taxes. The final dividend, on the other hand, is paid after the company
has declared its financial results. The company’s board of directors
declare the interim dividend and final dividend. Companies can pay an
interim dividend for part of a financial year (one-two quarters). However,
the final dividend is always annual. A company has the right to cancel
the interim dividend once announced, but it cannot cancel the final
dividend. 

Modigliani and Miller (MM) Approach

This theory was proposed by Franco Modigliani and Merton Miller in 1961 who
argued that the value of the firm is determined by the basic earning power, the
firm’s risk and not by the distribution of earnings. The value of the firm
therefore depends on the investment decisions and not the dividend decision.
However, their argument was based on some assumptions.

Assumptions of MM hypothesis
 The capital markets are perfect and all the investors behave rationally.

 There are no taxes and flotation costs and if the taxes are there then
there is no difference between the dividends tax and capital gains tax.

 No transaction costs associated with share floatation.

 The firm’s investment policy is independent of the dividend policy.

The effect of this assumption is that the new investments out of
retained earnings will not change and there will not change in the
required rate of return of the firm.

 There is perfect certainty by every investor as to future investments

and profits of the firm. Thus investors are able to forecast earnings and
dividends with certainty.
The MM hypothesis is based upon the arbitrage theory. The arbitrage process
involves switching and balancing the operations. Arbitrage leads to entering
into two transactions which exactly balance or completely offset the effect of
each other.

The two transactions are paying of dividends and raising external capital. Since
the firm uses retained earnings to finance new investments, the paying of
dividends will require the firm to raise the capital externally. The arbitrage
theory suggests that the dividend effect will be exactly offset by the effect of
raising additional share capital.
When the dividends are paid to the shareholders, the market price of share
decreases (because of external financing). Thus what is gained by the
shareholders as a result of dividends is completely neutralized by the reduction
in the market value of the shares.

According to MM, the investors will thus be indifferent between dividends and
retained earnings. The market value of the shares will depend entirely on the
expected future earnings of the firm.

Walter Approach
The Walter approach was given by James E Walter and is based on a simple
argument that where the reinvestment rate, that is, rate of return that the
company may earn on retained earnings, is higher than cost of equity (rate of
return of the shareholders), then it would be in the interest of the firm to retain
the earnings.

If the company’s reinvestment rate on retained earnings is the less than

shareholders’ rate of return, the company should not retain earnings. If the two
rates are the same, then the company should be indifferent between retaining
and distributing.

The Walter’s model is based on the following assumptions:

 The firm finances its entire investments by means of retained earnings
only.
 Internal rate of return (r) and cost of capital (KE) of the firm remains
constant.
 The firms’ earnings are either distributed as dividends or reinvested
internally.
 The earnings and dividends of the firm will never change.
 The firm has a very long or infinite life.

Walter Approach
The Walter approach was given by James E Walter and is based on a simple
argument that where the reinvestment rate, that is, rate of return that the
company may earn on retained earnings, is higher than cost of equity (rate of
return of the shareholders), then it would be in the interest of the firm to retain
the earnings.

If the company’s reinvestment rate on retained earnings is the less than

shareholders’ rate of return, the company should not retain earnings. If the two
rates are the same, then the company should be indifferent between retaining
and distributing.
The Walter’s model is based on the following assumptions:
 The firm finances its entire investments by means of retained earnings
only.
 Internal rate of return (r) and cost of capital (KE) of the firm remains
constant.
 The firms’ earnings are either distributed as dividends or reinvested
internally.
 The earnings and dividends of the firm will never change.
 The firm has a very long or infinite life.

Gordon Approch
Gordon Approch (The Bird-in-the-Hand Theory): The essence of the bird-in-
the-hand theory of dividend policy (advanced by John Litner in 1962 and
Myron Gordon in 1963) is that shareholders are risk-averse and prefer to receive
dividend payments rather than future capital gains. Shareholders consider
dividend payments to be more certain that future capital gains- thus a “bird in
the hand is worth more than two in the bush”.

Gordon contended that the payment of current dividends “resolves investor

uncertainty”. Investors have a preference for a certain level of income now
rather that the prospect of a higher, but less certain, income at some time in the
future.

The key implication, as argued by Litner and Gordon, is that because of the less
risky nature dividends, shareholders and investors will discount the firm’s
dividend stream at a lower rate of return, ‘r’, thus increasing the value of the
firm’s shares.

Assumptions of Gordon’s Model

The Gordon’s Model is based on the following assumptions:

1. The firm is an all equity firm.

2. There is no outside financing and all investments are financed
exclusively by retained earnings.
3. Internal rate of return (R) of the firm remains constant.
4. Cost of capital (KE) of the firm also remains same regardless of the
change in the risk complexion of the firm.
5. The firm derives its earnings in perpetuity
6. The retention ratio (b) once decided upon is constant. Thus the growth
rate (g) is also constant (g = br).
7. Corporate tax does not exist
According to Gordon, the market value of a share is equal to the present value
of the future streams of dividends. A simple version of Gordon’s model can be
presented as below:

P = E (1 – b) / KE – br

Where:
P = Price of a share
E = Earnings per share
b = Retention ratio
1 – b = Dividend payout ratio
KE = Cost of capital or the capitalization rate
br = Growth rate (rate or return on investment of an all-equity firm)