Module 3

Dividend decision & theories of

dividend
 Meaning of dividend
• Dividend is that portion of earnings, which is
distributed among the shareholders. In other
words, it refers to the divisible profits of a
company distributed or divided among its
shareholders in proportion to their
shareholdings.
 Dividend Policy
• Dividend policy is the policy of management
of a company concerning the portion of
profits to be distributed to shareholders as
dividends and portion of profits to be retained
in the company as retained earnings. In other
words, it determines the division of earnings
between payments to shareholders and
retained earnings. Formulation of proper
dividend policy is one of the major financial
decisions taken by the financial manager
 TYPES OF DIVIDEND

SCRIP BOND PROPERTY

CASH STOCK
 Scrip Dividend
• Scrip Dividend: When earnings of the company
justify dividend but the liquidity position does not
permit cash dividend
• it may declare dividend in the form of
promissory notes.
• Under this method, the shareholders are issued
transparent promissory notes instead of cash
dividend.
• This method is justified only when the company
has earned profit but it has to wait for conversion
of other current assets in to cash in hand.
• Bond Dividend: Some times the dividends are
paid in bonds or bills of exchange instead of cash.
• Effect of both Scrip dividend and Bond dividend is
the same except that the payment is postponed
in case of the Bond dividend.
• Under this method, the shareholders may have
to wait few months to convert their bonds into
cash.
• This method is also justified only when the
company has earned profit but it has to wait for
conversion of current assets in to cash in hand.
• Property Dividend: Under this method,
dividends are paid in the form of assets
instead of cash.
• This form of dividend may be followed in
those cases where there are assets which are
no longer necessary in the operations of the
business.
• This method is usually followed in Western
Countries and this is not in practice in India.
• 4. Cash Dividend: Cash dividend is the dividend,
which is distributed to shareholders in the form
of cash out of the earnings of the company. This
is an usual practice in Indian Corporate Sector.
• 5. Stock Dividend: In case of stock dividend the
company issues its own shares to the existing
shareholders in lieu of cash dividend. Payment of
stock dividend is popularly termed as issue of
bonus shares in India.
 Types of dividend policy
• Regular dividend policy
• Irregular dividend policy
• Stable dividend policy
• No dividend policy
• 1. Regular dividend policy Payment of dividend at
the usual rates is termed as regular dividend
policy.
• The investors such as the middle class families,
retired persons and institutional investors prefer
this type of dividend policy.
• However it should be remembered that regular
dividend can be maintained only by companies of
long standing and stable earnings.
 Irregular dividend policy

• Some companies follow irregular dividend policy due to

reasons such as lack of liquid funds, uncertainty of future
earnings, unsuccessful business operations etc.
• When a company does not have a long standing and stable
earnings, it will not be able in commit itself to paying
dividends regularly.
• When there is no certainty as to whether dividend will be
paid in a year or not and how much of dividend will be
paid, the company is said to follow a irregular dividend
policy.
• Investors who expect a company to pay a certain amount as
dividend every year may not want to invest in such a
company.
 Stable dividend policy

• The term stability of dividend means consistency or lack

of variability in the stream of dividend payments, even
though the amount of dividend may fluctuate from year to
year.
• The company decides to pay a certain amount of
dividend every year, consistently, whether more or less.
• Some investors may be more interested in a source of
income for today rather than capital appreciation.
• This serves as an assurance to those investors
who depend on dividend as a source of
income.
 Significance of stable dividend policy.
• Confidence among share holders
• Institutional investors
• Stability in market price for of shares
• Rising additional finance
• Spreading of ownership of outstanding share
• Reduces the chance of a loss of control
• Market for debentures and preference shares
1.Confidence among shareholders: Payment of regular and stable dividend may help in building
confidence in the minds of investors regarding regularity of dividends.
2. Investors' desire for current income: There are many investors like retired persons, salaried people,
and other fixed income group may prefer to receive income regularly to meet their living
expenses. Such investors prefer a company with stable dividend policy.
3. Institutional investors: Investments are made not only by individuals but also by institutions. Normally
the institutional investors prefer to invest in shares of those companies, which pay dividends
regularly:
4. Stability in market price of shares: Stable dividend policy may also help a company in maintaining
stability in the market price of its shares
5. Rising additional finance: A stable dividend policy is also advantageous to company in rising external
finance.
6. Spreading of ownership of outstanding share: Stable dividend policy may also help in spreading the
ownership of shares more widely among small investors
7. Reduces the chances of Loss of control: Because of the spreading of ownership for outstanding shares
among the large number of small investors the chances of Loss of control by the present
management over the company are reduced.
8. Market for debentures and preferences shares: A stable dividend policy also helps the company in
marketing of outstanding shares and debentures.
• No Dividend Policy
The company may follow a policy of paying no
dividend presently because of requirement of
funds for the future growth and expansion or
unfavorable working capital position.
company may decide not to pay any dividend at
all.
 Determinants of Dividend Policy
i) Type of Industry:
Industries that are characterized by stability of earnings
may formulate a more consistent policy as to dividends
than those having an uneven flow of income.
For example, public utilities concerns are in a much better
position to adopt a relatively fixed dividend rate than the
industrial concerns.
(ii) Age of Corporation:
Newly established enterprises require most of their earning
for plant improvement and expansion, while old companies
which have attained a longer earning experience, can
formulate clear cut dividend policies and may even be
liberal in the distribution of dividends
(iii) Extent of share distribution:
A closely held company is likely to get consent of
the shareholders for the suspension of dividends
or for following a conservative dividend policy.
But a company with a large number of
shareholders widely scattered would face a great
difficulty in securing such assent. Reduction in
dividends can be affected but not without the co-
operation of shareholders.
 (iv) Need for additional Capital:The extent to which the
profits are ploughed back into the business has got a
considerable influence on the dividend policy. The
income may be conserved for meeting the increased
requirements of working capital or future expansion.
(v) Business Cycles:
During the boom, prudent corporate management
creates good reserves for facing the crisis which follows
the inflationary period. Higher rates of dividend are
used as a tool for marketing the securities in an
otherwise depressed market.
(vi) Changes in Government Policies:Sometimes
government limits the rate of dividend declared
by companies in a particular industry or in all
spheres of business activity. The Government put
temporary restrictions on payment of dividends
by companies in July 1974 by making amendment
in the Indian Companies Act, 1956. The
restrictions were removed in 1975.
(vii) Trends of profits:
• (vii) Trends of profits:The past trend of the company’s
profit should be thoroughly examined to find out the
average earning position of the company. The average
earnings should be subjected to the trends of general
economic conditions. If depression is approaching, only a
conservative dividend policy can be regarded as prudent.
(viii) Taxation policy:Corporate taxes affect dividends directly
and indirectly— directly, in as much as they reduce the
residual profits after tax available for shareholders and
indirectly, as the distribution of dividends beyond a certain
limit is itself subject to tax. At present, the amount of
dividend declared is tax free in the hands of shareholders.
• (ix) Future Requirements:Accumulation of profits
becomes necessary to provide against contingencies
(or hazards) of the business, to finance future-
expansion of the business and to modernise or replace
equipments of the enterprise. The conflicting claims of
dividends and accumulations should be equitably
settled by the management.
• (x) Cash Balance:If the working capital of the company
is small liberal policy of cash dividend cannot be
adopted. Dividend has to take the form of bonus
shares issued to the members in lieu of cash payment.
 Dividend Theories
• Theories of Relevance
1. Walter’s Model
2. Gordon’s Model
• Theories of Irrelevance
1. The Miller – Modigliani
• The second school of thought explains the
relevance of the dividend policy and the
impact of the same on the share value of the
firm. The advocates of this school of thought
include Prof. James E. Walter and Myron
Gordon. According to them, the firms which
pay higherdividends will enjoy more value as
compared to those firms which pay a lower or
no dividends
• Prof. Walter's approach supports the doctrine
that dividend decisions are relevant and
affects the value of the firm. The relation
between the internal rate of return earned by
the firm (r) and its cost of capital (k) is very
significant in determining the dividend policy.
Prof Walter's model is based on the
relationship between the firm's return on
investments (r) andthe cost of capital (k).
• (r>k)
• (r<k)