DETERMINANTS OF DIVIDEND

POLICY

Factors

Bonus Shares (Stock Dividend) and

Stock (Share) Splits

Legal, Procedural and Tax Aspects

Solved Problems
FACTORS
1) Dividend payout (D/P) ratio
2) Stability of dividends
3) Legal, contractual and internal constraints
and restrictions
4) Owner’s considerations
5) Capital market considerations
6) Inflation
 (1) Dividend Payout (D/P) Ratio

The D/P ratio indicates the percentage share of the

net earnings distributed to the shareholders as
dividends. Given the objective of wealth
maximisation, the D/P ratio should be such as can
maximise the wealth of its owners in the ‘long-run’.
In practice, investors, in general, have a clear cut
preference for dividends because of uncertainty and
imperfect capital markets. Therefore, a low D/P ratio
may cause a decline in share prices, while a high
ratio may lead to a rise in the market price of the
shares.
The D/P ratio of the Reliance Industries Ltd. (RIL) is summarised in Exhibit 31.1
EXHIBIT 31.1 D/P Ratio of RIL, 2005-12

Year Dividend payout ratio

2012 14.68
2011 13.66
2010 14.97
2009 14.50
2008 9.81
2007 13.75
2006 17.52
2005 15.79
Mean (2005-2012) 14.34
Mean (2005-2008) 14.22
Mean (2009-2012) 14.45
 (2) Stability of Dividends
Stable dividend policy refers to the consistency or lack of variability in the
stream of dividends, that is, a certain minimum amount of dividend is paid
out regularly. Of the three forms of stability of dividend, namely, constant
dividend per share, constant D/P ratio and constant dividend per share plus
extra dividend, the first one is the most appropriate. The investors prefer a
stable dividend policy for a number of reasons, such as, desire for current
income their, informational contents, institutional requirement, and so on.
Constant dividend per share policy is a policy of paying a certain fixed
amount per share as dividend.
Constant/target payout ratio is a policy to pay a constant percentage of net
earnings as dividend to shareholders in each dividend period.
Stable rupee plus extra dividend is a policy based on paying a fixed dividend
to shareholders supplemented by an additional dividend when earnings
warrant it.
 EPS

ESP and DPS (Rs) DPS

Times (Years)

Figure 1: Stable Dividend Policy

It can, thus, be seen that while the earnings may fluctuate from year to year,
the dividend per share is constant. To be able to pursue such a policy, a
firm whose earnings are not stable would have to make provisions in years
when earnings are higher for payment of dividends in lean years. Such
firms usually create a ‘reserve for dividends equalisation’. The balance
standing in this fund is normally invested in such assets as can be readily
converted into cash.
 (3) Legal, Contractual, and Internal
Constraints and Restrictions

Legal Requirements  Legal stipulations do not

require a dividend declaration but they specify
the conditions under which dividends must be
paid. Such conditions pertain to
a) Capital impairment
b) Net profits
c) Insolvency
(a) Capital Impairment Rules
Legal enactments limit the amount of cash dividends that a firm may pay. A firm
cannot pay dividends out of its paid-up capital, otherwise there would be a
reduction in the capital adversely affecting the security of its lenders. The
rationale of this rule lies in protecting the claims of preference shareholders and
creditors on the firm’s assets by providing a sufficient equity base since the
creditors have originally relied upon such an equity base while extending credit.
(b) Net Profits
The net profits requirement is essentially a corollary of the capital impairment
requirement, in that it restricts the dividend to be paid out of the firm’s current
profits plus past accumulated retained earnings. Alternatively, a firm cannot pay
cash dividends greater than the amount of current profits plus the accumulated
balance of retained earnings.
(c) Insolvency
A firm is said to be insolvent in two situations: first, when its liabilities exceed the
assets; and second, when it is unable to pay its bills. The rationale of the rule is to
protect the creditors by prohibiting the liquidation of near-bankrupt firms through
cash dividend payments to the equity owners.
 Contractual Requirements
Important restrictions on the payment of dividend may be accepted by a
company when obtaining external capital either by a loan agreement, a
debenture indenture, a preference share agreement, or a lease contract.
Such restrictions may cause the firm to restrict the payment of cash
dividends until a certain level of earnings has been achieved or limit the
amount of dividends paid to a certain amount or percentage of earnings.
Since the payment of dividend involves a cash outflow, firms are forced
to reinvest the retained earnings within the firm.
Therefore, contractual constraints on dividend payments are quite
common. The payment of cash dividend in violation of a restriction would
amount to default in the case of a loan and the entire principal would
become due and payable. Keeping in view the severity of penalty, the
financial manager must ensure that the amount of dividend is within the
covenants already committed to lenders.
 Internal Constraints
Liquid Assets  Once the payment of dividend is permissible on legal and
contractual grounds, the next step is to ascertain whether the firm has sufficient
cash funds to pay cash dividends.
Growth Prospects  Another set of factors that can influence dividend policy
relates to the firm’s growth prospects. The firm is required to make plans for
financing its expansion programmes.
Financial Requirements  Financial requirements of a firm are directly related to
its investment needs. The firm should formulate its dividends policy on the basis
of its foreseeable investment needs
Availability of Funds  The dividend policy is also constrained by the availability
of funds and the need for additional investment. In evaluating its financial
position, the firm should consider not only its ability to raise funds but also the
cost involved in it and the promptness with which financing can be obtained.
Earnings Stability  The stability of earnings also has a significant bearing on the
dividend decision of a firm. Generally, the more stable the income stream, the
higher is the dividend payout ratio.
Control  Dividend policy may also be strongly influenced by the shareholders’ or
the management’s control objectives. That is to say, sometimes management
employs dividend policy as an effective instrument to maintain its position of
command and control.
 Owner’s Considerations
Taxes  The dividend policy of a firm may be dictated by the income tax
status of its shareholders. If a firm has a large percentage of owners who
are in high tax brackets, its dividend policy should seek to have higher
retentions. Such a policy will provide its owners with income in the form
of capital gains as against dividends. Since capital gains are taxed at a
lower rate than dividends, they are worth more, after taxes, to the
individuals in a high tax bracket.
Opportunities  The firm should not retain funds if the rate of return
earned by it would be less than one which could have been earned by the
investors themselves from external investments of funds.
Dilution of Ownership  The financial manager should recognise that a
high D/P ratio may result in the dilution of both control and earnings for
the existing equity holders. Dilution in earnings results because low
retentions may necessitate the issue of new equity shares in the future,
causing an increase in the number of equity shares outstanidng and
ultimately lowering earnings per share and their price in the market. By
retaining a high percentage of its earnings, the firm can minimise the
possibility of dilution of earnings.
Capital Market Considerations
Yet another set of factors that can strongly affect dividend policy is the
extent to which the firm has access to the capital markets. In case the firm
has easy access to the capital market, either because it is financially strong
or large in size, it can follow a liberal dividend policy. However, if the firm
has only limited access to capital markets, it is likely to adopt low dividend
payout ratios. Such firms are likely to rely more heavily on retained earnings
as a source of financing their investments.
Inflation
Finally, inflation is another factor which affects the firm’s dividend decision.
With rising prices, funds generated from depreciation may be inadequate to
replace obsolete equipments. These firms have to rely upon retained
earnings as a source of funds to make up the shortfall. This aspect becomes
all the more important if the assets are to be replaced in the near future.
Consequently, their dividend payout tends to be low during periods of
inflation.
 BONUS SHARES (STOCK DIVIDEND) AND
STOCK (SHARE) SPLITS

Apart from cash dividend, a firm can also reward its investors by
paying bonus shares. The bonus shares/share splits do not have
any economic impact on the firm in that its assets, earnings and
investors’ proportionate ownership remain unchanged. As a
result, the number of shares outstanding increases. The increased
number of shares outstanding tends to bring the market price of
shares within more popular range and promote more active
trading in shares. Moreover, bonus/split announcements have
informational content to the investors. It will also enable the
conservation of corporate cash and further enable a firm to raise
additional funds particularly through the issue of convertible
securities.
 Reverse Stock Splits
Instead of increasing the number of shares outstanding, a
company may like to reduce it through a reverse split. There is no
impact of the reverse split on corporate earnings and
shareholders’ wealth. Reverse split reflects an aversion on the
part of many companies to see the prices of their shares falling
below a certain amount. Whatever be the reasons for decrease of
price, it can be increased with a reverse split.
In the case of straight stock split, the number of outstanding
shares increases, but it decreases when the company chooses
reverse split. The reverse split of 1:5 implies that for each five
shares held by a shareholder, he would receive one share in
exchange. The company L.G. Balakrishnan & Brothers Limited
has gone for reserve split of 1:10 in March 2010.
 Share Repurchase (Share Buyback)

Share repurchase implies that a company buys back its own

shares. It is an alternative method to pay cash dividends. Share
repurchases reduce the number of equity shares outstanding in
the market. Given no change in corporate earnings and price-
earning ratio, share repurchase would result in higher (i) EPS and
(ii) market price of a share. Moreover, such repurchases not only
convey a positive signal to shareholders that management
believes that the share is under-valued but also helps in
preventing decline in the firm’s share prices. Example 31.1
illustrates that share repurchases is similar to the payment of
cash dividends.