What is a Dividend?

A dividend is a share of profits and retained earnings that a company pays out to its shareholders
and owners. When a company generates a profit and accumulates retained earnings, those
earnings can be either reinvested in the business or paid out to shareholders as a dividend. The
annual dividend per share divided by the share price is the dividend yield.

According to the Institute of Chartered Accountant of India,

Dividend is defined as “ a distribution to shareholders out of profits or reserves available for this
purpose”.

According to Supreme Court Of India,

Dividend is the proportion of profits of the company which is allocated to the holders of shares in the
company.

What are the Different Types of Dividends?

If you want to know what are the types of dividend that businesses pay out, each with its
advantages and disadvantages, keep reading.

1. Cash dividends
These are the most common type of dividends, paid out in cash. A company pays out a certain
portion of its profits as dividends to shareholders. For example, An IT firm, XYZ, has made Rs
500 crores in profit for the year 2020. They decided to pay their shareholders 20% of that amount
as a dividend, which would be Rs 100 Crore INR (500 Cr x 0.20).

This would mean each shareholder would receive a certain dividend amount, depending on how
much stock they own.

The advantages and disadvantages of cash dividends depend on the company's financial
situation. On the one hand, shareholders can benefit from receiving a dividend payment in the
form of cash; on the other hand, companies have less money to reinvest in their businesses,
which can limit growth potential.

Cash dividends provide an immediate return but also mean less money for companies to reinvest
and grow.

2. Stock dividends
As the name suggests, stock dividends are paid out as additional shares instead of cash. For
example, XYZ IT firm decided to pay its shareholders 20% of its profits as a stock dividend.
This would mean each shareholder will receive an additional share for every five shares they
own.

The advantage of stock dividends is that they can increase a shareholder's potential returns
without them having to invest more money. Additionally, companies won't have to part with
their profits as they do with cash dividends.
On the downside, they also don't provide immediate benefits and tend to carry more risk than
cash dividends. The market value of the new shares could be lower or higher than when the
original investment was made.
3. Property dividends
These various forms of dividend are paid out as assets instead of cash or shares. This could be
anything from real estate to antiques and can even include intangible assets such as patents or
copyrights.

The advantage of property dividends is that they can diversify an investment portfolio and may
provide more tax benefits than other types of dividends. On the downside, there is always a risk
that the value of these types of assets may decline over time, limiting potential returns.
For example, XYZ IT firm pays its shareholders 10% of its profits as property dividends. This
would mean each shareholder will receive an additional asset worth Rs 50 Lakhs INR (500 Cr x
0.10).
4. Scrip dividends/Bond Dividend
Scrip dividends are similar to stock dividends, but instead of receiving additional shares directly
from the company, shareholders receive a scrip or voucher that can be exchanged for shares on
the market.

The advantage of scrip dividends is that they can provide more flexibility to investors as it allows
them to decide when and how much of their dividend money should be used for reinvestment.
On the downside, there is always a risk that the value of these types of assets may decline over
time, limiting potential returns.

For example, XYZ IT firm decides to pay its shareholders 10% of its profits as a scrip dividend.
This would mean each shareholder will receive a scrip worth Rs 50 Lakhs INR (500 Cr x 0.10)
that can be exchanged for market shares later.

5. Composite Dividend
When dividend consist of both cash as well as property.

6. Interim Dividend

An interim dividend is a dividend payment made before a company's annual general meeting and
before the release of final financial statements. This declared dividend usually accompanies the
company’s interim financial statements and is paid out monthly or quarterly.

What is a Dividend Policy?

A company’s dividend policy dictates the amount of dividends paid out by the company to its
shareholders and the frequency with which the dividends are paid out. When a company makes a
profit, they need to make a decision on what to do with it. They can either retain the profits in the
company (retained earnings on the balance sheet), or they can distribute the money to
shareholders in the form of dividends.

The dividend policy used by a company can affect the value of the enterprise. The policy chosen
must align with the company’s goals and maximize its value for its shareholders. While the
shareholders are the owners of the company, it is the board of directors who make the call on
whether profits will be distributed or retained.

The directors need to take a lot of factors into consideration when making this decision, such as
the growth prospects of the company and future projects. There are various dividend policies a
company can follow such as:

1. Regular dividend policy

Under the regular dividend policy, the company pays out dividends to its shareholders every
year. If the company makes abnormal profits (very high profits), the excess profits will not be
distributed to the shareholders but are withheld by the company as retained earnings. If the
company makes a loss, the shareholders will still be paid a dividend under the policy.

The regular dividend policy is used by companies with a steady cash flow and stable earnings.
Companies that pay out dividends this way are considered low-risk investments because while
the dividend payments are regular, they may not be very high.

2. Stable dividend policy

Under the stable dividend policy, the percentage of profits paid out as dividends is fixed. For
example, if a company sets the payout rate at 6%, it is the percentage of profits that will be paid
out regardless of the amount of profits earned for the financial year.

Whether a company makes $1 million or $100,000, a fixed dividend will be paid out. Investing
in a company that follows such a policy is risky for investors as the amount of dividends
fluctuates with the level of profits. Shareholders face a lot of uncertainty as they are not sure of
the exact dividend they will receive.

3. Irregular dividend policy

Under the irregular dividend policy, the company is under no obligation to pay its shareholders,
and the board of directors can decide what to do with the profits. If they make an abnormal profit
in a certain year, they can decide to distribute it to the shareholders or not pay out any dividends
at all and instead keep the profits for business expansion and future projects.

The irregular dividend policy is used by companies that do not enjoy a steady cash flow or
lack liquidity. Investors who invest in a company that follows the policy face very high risks as
there is a possibility of not receiving any dividends during the financial year.

4. No dividend policy

Under the no-dividend policy, the company doesn’t distribute dividends to shareholders. It is
because any profits earned are retained and reinvested into the business for future growth.
Companies that don’t give out dividends are constantly growing and expanding, and
shareholders invest in them because the value of the company stock appreciates. For the investor,
the share price appreciation is more valuable than a dividend payout.
Factors Influencing Dividend Policy

Many factors influence a company's dividend policy, including:

1. Legal Restrictions: The legal restrictions that influence dividend policy are as follows:

 Dividends can only be paid out of profit and not out of capital

 Companies can declare and pay dividends using the previous year's profit

 At least 10% of profit must be transferred to the company's reserves

 Dividends are payable in cash, but by following legal formalities, dividends can also be
paid in bonus shares or assets

2. Size of Earnings: Dividend policy is dependent on the earnings of the firm. It is not only the
amount of dividend but also the nature of the earnings that bears upon dividend policy. A stable
dividend policy is preferable.

3. Shareholder Preferences: Management should follow a policy that suits the interests not only
of the company but also its shareholders.

4. Liquidity Position: A company's dividend policy must consider the liquidity position of the
company. The payment of dividends reduces the company's cash reserves of the company.

Growing companies have a pressing need for funds, and so, for these companies, the payment of
dividends in cash should be avoided.

5. Management Attitude: Some companies use internal sources to finance expansion programs
because issuing new shares would alter the control of the company.

When debentures are issued to finance expansion, this runs the risk of causing the earnings of
existing members to fluctuate.

6. Condition of Capital Market: When the capital market is comfortable, companies can follow
a liberal dividend policy.

7. Stability of Earnings: When a company is making remarkable progress and has stable
earnings, a liberal dividend policy can be followed.
8. Trade Cycle: When there is inflation in the country, the company will earn more profit.
Therefore, the company can distribute more dividends and, when it needs funds, these can be
borrowed externally at a favorable interest rate.

9. Ability to Borrow: A company that can borrow from external sources at a cheap rate can
borrow from the outside. In such cases, the cost of borrowed capital and retained earnings can be
compared.

10. Past Dividend Rate: While deciding on a dividend policy, managers and the board of
directors should pay attention to the dividend rate in previous years.

DIVIDEND THEORIES

Dividend decision is a financial decision. There are conflicting theories regarding impact of
dividend decision on the valuation of a firm. These theories are grouped into the following two
categories:

1. Irrelevant concept of dividend

2. Relevance concept of dividend

Irrelevant concept of Dividend

Dividend irrelevance theory suggests that a company’s payment of dividends should have little
to no impact on the stock price. If this theory holds true, it would mean that dividends do not
add value to a company’s stock price.

1. Solomon Approach

 According to Ezra Solomon, the dividend policy of a firm is a residual decision and
dividend is a passive residual.
 Investor thinks to retain and reinvest earning rather than giving them as dividend.
 Their principal desire is to earn higher return on their capital.

2. Modigliani and Miller’s Approach

Modigliani and Miller (MM) expressed their opinion in a more comprehensive way.
 The authors argue that a company's share price is determined by its earning potential and
investment policy, not by the pattern of income distribution.

Under the condition of a perfect capital market, rational investors, absence of tax
discrimination between dividend income and capital appreciation given in the company's
investment policy. If dividends have no influence on share price.

The logic given by the above school of thought is that whatever increase in shareholder
wealth results from dividend payments, it will be exactly offset by the effect of raising
additional capital.

Example

If a company with investment opportunities distributes its earnings to shareholders, it will

need to raise capital externally. This will increase the number of shares, leading to a decline
in share price.

Therefore, whatever a shareholder receives due to the higher dividend payment will be
counterbalanced and neutralized with the falling share price and declining
expected earnings per share.

Assumptions of MM Hypothesis

The MM hypothesis is based on the following assumptions:

 Capital markets are perfect.

 Investors behave rationally. Information is freely available to them and there are
no floatation and transaction costs.

 There are no taxes and no differences in the tax rates applicable to capital gains and
dividends.

 The firm has a fixed investment policy.

 Risk or uncertainty does not exist. Investors can forecast future prices and dividends with
certainty. One discount rate can be used for all securities at all times.
Proof of MM Hypothesis

The market value of a share at the beginning of a period is equal to the present value of
dividends paid at the end of the period plus the share price at the end of the period.

This can be expressed as follows:

Po = (D1 + P1) / (1+ Ke)

where

Po = Prevailing market price of a share

P1 = Market price of share at the end of period one

Ke = Cost of equity share

D1 = Dividend to be received at the end of period one

The value of P1 can be further expressed as:

P1 = PO (1+Ke) - D1

Criticisms of MM Hypothesis

The main criticisms of the MM hypothesis focus on its assumptions.

1. Tax differential: The assumption that taxes do not exist is far from reality.

2. Floatation cost: A firm has to pay financing cost in the form of underwriting
commission, brokerage, and so on. As a result, external financing is costlier than internal.

3. Transaction costs: In reality, shareholders need to pay brokerage fees and other fees
when they sell shares. This is one reason why shareholders may prefer to have dividends.

4. Discount rate: The use of a single discount rate to discount cash inflow over different
periods is incorrect. Uncertainty increases over time, which means that many investors
prefer small dividends now over large dividends later.
Relevance Theory of Dividends

Several authors, including M. Gorden, John Linter, James Walter, and Richardson, are
associated with the relevance theory of dividends.

According to these authors, a well-reasoned dividend policy can positively influences a

firm's position in the stock market.

Higher dividends will increase the value of stock, whereas low dividends will have the
opposite effect.

It is increasingly a reality today that dividends provide an indication of an organization's

growing profitability over time.

Walter's Approach

According to James Walter, dividend policy always affects the goodwill of a company.
Walter argued that dividend policy reflects the relationship between the firm's return on
investment or internal rate of return and the cost of capital or required rate of return.

Suppose that r is the internal rate of return and K is the cost of equity capital. Then, for any
given company, we have the following cases:

Case 1: When r > k

Firms with r > k are termed growth firms. Their optimal dividend policy involves
ploughing back the company's entire earnings.

Thus, the dividend payment ratio would be zero. This would also maximize the market
value of the company's shares.

Case 2: When r < k

Firms with r < k do not offer profitable investment opportunities. For these firms, the
optimal dividend policy involves distributing the entire earnings in the form of dividends.

Shareholders can use dividends to receive in other channels when they can get a higher rate
of dividends.
Thus, 100% dividend payout ratio in their case would result in maximizing the value of the
equity shares.

Case 3: When r = k

For firms with r = k, it does not matter whether the firm retains or distributes its earnings.
In their case, the share price would not fluctuate with a change in dividend rates.

Thus, no optimal dividend policy exists for such firms.

Assumptions in Models Based on Walter's Approach

(i) The firm undertakes its financing entirely through retained earnings. It does not use
external sources of funds such as debts or new equity capital.

(ii) The firm's business risk does not change with additional investment. This means that
the firm's internal rate of return and cost of capital remain constant.

(iii) Initially, earnings per share (EPS) and dividend per share (DPS) remain constant. The
choice of values for EPS and DPS varies depending on the model, but any given values are
assumed to remain constant.

(iv) The firm has a very long life.

Formula for Walter's Approach

The market value of a share (P) can be expressed as follows:

Criticisms:

 The assumption that investments are financed through internal sources is not true.
External sources are also used for financing.
 The ratio between r and k is not constant in an organization. As investment
increases, r also increases.
 Earnings and dividends do not charge while determining the value.
 The assumption that a firm will have a long life is difficult to predict.

Gorden's Approach

Gorden proposed a model along the lines of Walter, suggesting that dividends are relevant
and that the dividends of a firm influence its value. The defining feature of Gordon’s model
is that the value of a dollar in dividend income is greater than the value of a dollar in capital
gain. This is due to the uncertainty of the future and the shareholder's discount future
dividends at a higher rate. According to Gorden, the market value of a share is equal to the
present value of the future stream of dividends.

Assumptions of the Gordon Growth Model

The Gordon Growth Model assumes the following conditions:

 The company’s business model is stable; i.e. there are no significant changes in its
operations
 The company grows at a constant, unchanging rate
 The company has stable financial leverage
 The company’s free cash flow is paid as dividends

Formula for Gorden’s Approach

The formula is given as follows:

P = E (1 - b) / (Ke - br)

or

P = D / (Ke - g)
where

P = Share price

E = Earnings per share

b = Retention ratio

Ke = Cost of equity capital

br = g

r = Rate of return on investment

D = Dividend per share

Limitations of the Gordon Growth Model

The main limitation of the Gordon growth model lies in its assumption of constant growth
in dividends per share. It is very rare for companies to show constant growth in their
dividends due to business cycles and unexpected financial difficulties or successes. The
model is thus limited to firms showing stable growth rates.

The second issue occurs with the relationship between the discount factor and the growth
rate used in the model. If the required rate of return is less than the growth rate of dividends
per share, the result is a negative value, rendering the model worthless. Also, if the required
rate of return is the same as the growth rate, the value per share approaches infinity.