Dividend policy

1. Concept & Meaning:-

Meaning:-
(i) Introduction: - The term dividend derived from Anglo-Norman French dividend refers to that portion
of profit (after tax) which is distributed among the owners/shareholders of the firm. Dividend is a part
of profit which is being paid to the shareholder as remuneration to his contribution to the capital. The
part of profit which is not distributed is called retained earnings.

Net profit Dividend

after tax

Retained Earnings

Dividends can be paid from current year profits or accumulated profits. Dividends are paid quarterly,
half yearly or annually. If its paid half yearly it is called interim dividends. The following are few concepts
with respect to dividend.

Dividend rate: - Dividend expressed as a percentage of face value.

Dividend yield: - Dividend expressed as a percentage of market price.
Dividend pay-out: - Dividend expressed as a percentage of earnings per share.

(ii) Dividend policy: - The dividend policy of a firm is determines what proportion of earnings is to be
distributed by way of dividends and what proportion is to be ploughed back for reinvestment. Since
each firm faces a combination of potentially different market friction each firm has a unique optimal
dividend policy. The policy is an enumeration of the dividend decision taken by the company, dividend
decision being one of the three main financial decisions has a huge impact on the finances. It is a
decision made by the Board of Directors of a company and approved by the shareholders at the
general meeting. Shareholders do not have the right to ask for divided nor increase in the rate of
dividend as the Board has the unfettered right. However, this power cannot be used arbitrarily or
advantageously by the Board and therefore the Board has to evolve a dividend policy that maximize
shareholders wealth. Since dividend decision relates to the amount and timing of any cash payments
made to the company's stakeholders, the decision is an important one for the firm as it may influence
its capital structure and stock price. In addition, the decision may determine the amount of taxation
that shareholders have to pay. The various types of dividend policies are discussed as follows:

(a) Constant Dividend Per Share: Some companies follow a policy of paying fixed dividend per share
irrespective of level of earnings year after year. Such firms usually create a Reserve for Dividend
Equalisation to enable them pay fixed dividend even in year when earnings are not sufficient or when
there are losses. A policy of constant dividend per share is most suitable to concerns whose earnings
are expected to remain stable over number of years. The policy doesnt mean that the dividends will
never increase, the company reaches new level of earnings and expects to maintain it, and the annual
dividend per share may be increased.
(b) Constant Pay-out ratio: It means payment of fixed percentage of net earnings as dividends every
year. The amount of dividend in such a policy fluctuates in direct proportion to earnings of company.
The policy of constant pay-out is preferred by the firms because it is related to their ability to pay
dividends. Such a policy envisages that the amount of dividend fluctuates in direct proportion to
earnings. If a company adopts 40% pay-out ratio, then 40% of every rupee of net earnings will be paid
out. If a company earns ` 2/- per share, dividend per share will be 80 paise and if it earns ` 1.50 per
share, dividend per share will be 60 paise

(c) Stable rupee Dividend plus extra dividend: Some companies follow a policy of paying constant low
dividend per share plus an extra dividend in the years of high profit. Such a policy is most suitable to
the firm having well established cash flow. By paying extra dividend in period of prosperity, it enables
the company to pay constant amount of dividend regularly This policy allows some shareholders to plan
on set amounts of cash and at the same time be pleased when extra dividends are announced

(d)Residual Approach: - Under this approach dividends are paid out of profits after retaining money
required to meet upcoming capital expenditure commitments. Dividend =PAT- Capital Exp.

(iii) Reasons for payment of dividend:-

2. Kinds of Dividend:-
Dividend:-
(i) Cash dividend: The Company should have sufficient cash in bank account when cash dividends are
declared. If it does not have enough bank balance, it should borrow funds. For stable dividend policy a
cash budget may be prepared for coming period to indicate necessary funds to meet regular dividend
payments. The cash account and reserve account of the company will be reduced when cash dividend
is paid. Both total assets and net worth of the company are reduced when cash dividend is distributed.

(ii) Stock Dividend (Bonus shares): It is distribution of shares in lieu of cash dividend to existing
shareholders. Such shares are distributed proportionately thereby retaining proportionate ownership
of the company. If a shareholder owns 100 shares at a time, when 10% dividend is declared he will
have 10 additional shares thereby increasing the equity share capital and reducing reserves and surplus
(retained earnings). The total net worth is not affected by bonus issue.
3. Determinants & Constraints:
Constraints:-
(i) Financial Needs of The Company: Retained earnings can be a source of finance for creating profitable
investment opportunities. When internal rate of return of a company is greater than return required
by shareholders, it would be advantageous for the shareholders to re-invest their earnings. Risk and
financial obligations increase if a company raises debt through issue of new share capital where
floatation costs are involved. Mature companies having few investment opportunities will show high
payout ratios; share prices of such companies are sensitive to dividend charges. So a small portion of
the earnings are kept to meet emergent and occasional financial needs. Growth companies, on the
other hand, have low payout ratios. They are in need of funds to finance fast growing fixed assets.
Distribution of earnings reduces the funds of the company. They retain all the earnings and declare
bonus shares to offset the dividend requirements of the shareholders. These companies increase the
amount of dividends gradually as the profitable investment opportunities start falling.

(ii) Liquidity: Payment of dividends means outflow of cash. Ability to pay dividends depends on cash
and liquidity position of the firm. A mature company does not have much investment opportunities,
nor are funds tied up in permanent working capital and, therefore has a sound cash position. For a
growth oriented company in spite of good profits, it will need funds for expanding activities and
permanent working capital and therefore it is not in a position to declare dividends

(iii) Desire of Shareholders: The desire of shareholders (whether they prefer regular income by way of
dividend or maximize their wealth by way of gaining on sale of the shares). Small shareholders who are
concerned with regular dividend income or who do not form a dominant group or retired and old
people investing their savings, pension to purchase shares may prefer regular income and hence select
shares of companies paying regular and liberal dividend. As compared to those shareholders who
prefer regular dividend as source of income, there are shareholders who prefer to gain on sale of
shares at times when shares command higher price in the market.

The dividend policy, thus pursued by the company should strike a balance on the desires of the
shareholders who may belong either of the group as explained above. Also the dividend policy once
established should be continued as long as possible without interfering with the needs of the company
to create clientele effect.

(iv) Nature of Industry: Nature of Industry to which company is engaged also considerably affects
dividend policy. Certain industries have comparatively steady and stable demand irrespective of
prevailing economic conditions. For example, people used to drink liquor both in boom as well as in
recession. Such firms expect regular earnings and hence follow consistent dividend policy. On the other
hand, if earnings are uncertain, as in the case of luxury goods conservative policy should be followed.
Such firms should retain a substantial part of their current earnings during boom period in order to
provide funds to pay adequate dividends in the recession periods. Thus, industries with steady demand
of their products can follow a higher dividend payout ratio while cyclical industries should follow a
lower payout ratio.

(v)Age of Company: It also influences dividend decision of company. A nearly established concern has
to limit payment of dividend and retain substantial part of earnings for financing its future growth while
older companies which have established sufficient reserves can afford to pay liberal dividends.
(vi) Stability of Dividends: Stability of dividend refers to payment of dividend regularly and shareholders
generally, prefer payment of such regular dividends. Some companies follow a policy of constant
dividend per share while others follow a policy of constant payout ratio and while there are some other
who follow a policy of constant low dividend per share plus an extra dividend in years of high profits. A
policy of constant dividend per share is most suitable to concerns whose earnings are expected to
remain stable over a number of years or those who have built up sufficient reserves to pay dividends in
years of low profits. The policy of constant payout ratio i.e. paying a fixed percentage of net earnings
every year may be supported by firm because it is related to firms ability to pay dividends. The policy
of constant low dividend per share plus some extra dividend in years of high profits is suitable to firms
having fluctuating earnings from year to year.

(vii)Magnitude and Trend of Earnings: The amount and trend of earnings is an important aspect of
dividend policy. It is rather the starting point of the dividend policy. As dividends can be paid only out
of present or pasts years profits, earnings of a company fix the upper limits on dividends. The dividends
should nearly be paid out of current years earnings only as retained earnings of the previous years
become more or less a part of permanent investment in the business to earn current profits. The past
trend of the companys earnings should also be kept in consideration while making dividend decision.

(viii)Control objectives: When a company pays high dividends out of its earnings, it may result in dilution
of both control and earnings for existing shareholders. As in case of high dividend payout ratio the
retained earnings are insignificant and company will have to issue new shares to raise funds to finance
its future requirements. The control of the existing shareholders will be diluted if they cannot buy
additional shares issued by the company. Similarly issue of new shares shall cause increase in number
of equity shares and ultimately cause a lower earnings per share and their price in the market. Thus
under these circumstances to maintain control of the existing shareholders, it may be desirable to
declare lower dividends and retain earnings to finance the firms future requirements.

(ix) Access to the Capital Market: By paying large dividends, cash position is affected. If new shares
have to be issued to raise funds for financing investment programmes and if the existing shareholders
cannot buy additional shares, control is diluted. Payment of dividends may be withheld and earnings
are utilized for financing firms investment opportunities.

(x) Taxation: - As per the current provisions of the Income Tax Act, 1961, tax on dividend is borne by
the corporate as (Dividend Distribution Tax) and shareholders need not pay any tax on income received
by way of dividend from domestic companies. On sale of shares, as per the provisions of the Income
Tax Act, 1961, tax on capital gains (short-term @ 15%) are attracted if they sell the shares on holding
less than one year and there is no tax on long-term sale (if held for more than one year). However,
shareholders have to pay Securities Transaction Tax (STT) on sale of shares.

4. Legal Considerations
(i) Section 123 of the Companies Act, 2013:- According to this section:
(a) Dividend shall be declared or paid by a company for any financial year only
out of the profits of the company for that year arrived at after providing for depreciation in
accordance with the provisions of section 123(2), or

out of the profits of the company for any previous financial year or years arrived at after
providing for depreciation in accordance with the provisions of that sub-section and remaining
undistributed, or
 out of both; or
out of money provided by the Central Government or a State Government for the payment of
dividend by the company in pursuance of a guarantee given by that Government.

(b) Transfer to reserves: A company may, before the declaration of any dividend in any financial
year, transfer such percentage of its profits for that financial year as it may consider appropriate
to the reserves of the company. Therefore, the company may transfer such percentage of profit
to reserves before declaration of dividend as it may consider necessary. Such transfer is not
mandatory and the percentage to be transferred to reserves is to be decided at the discretion
of the company.

(c) Declaration of dividend out of accumulated profits: Where a company, owing to inadequacy or
absence of profits in any financial year, proposes to declare dividend out of the accumulated
profits earned by it in previous years. Such dividend shall be declared or paid by a company
only from its free reserves. No other reserve can be utilized for the purposes of declaration of
such dividend. For declaration of dividend out of accumulated profits the following conditions
shall be fulfilled:

The rate of dividend declared shall not exceed the average of the rates at which
dividend was declared by it in the 3 years immediately preceding that year: However, this rule
will not apply if a company has not declared any dividend in each of the three preceding
financial year.
The total amount to be drawn from such accumulated profits shall not exceed one-
tenth of the sum of its paid-up share capital and free reserves as appearing in the latest audited
financial statement. Therefore,

Total amount that can be 1/10 of (Paid up share capital

drawn +
from accumulated profits Free reserves)

The amount so drawn shall first be utilised to set off the losses incurred in the financial
year in which dividend is declared before any dividend in respect of equity shares is declared.

The balance of reserves after such withdrawal shall not fall below 15% of its paid up
share capital as appearing in the latest audited financial statement.

(d) Depositing of amount of dividend: In terms of section 123(4), the amount of the dividend,
including interim dividend, shall be deposited in a scheduled bank in a separate account
within five days from the date of declaration of such dividend.

(e) Payment of dividend: According to section 123(5):

Dividends are payable in cash. Dividends that are payable to the shareholder in cash
may be paid by cheque or warrant or in any electronic mode.

Dividend shall be payable only to the registered shareholder of the share or to his
order or to his banker.
 Nothing in sub-section 5 of section 123, shall prohibit the capitalisation of profits or
reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any
amount for the time being unpaid on any shares held by the members of the company.
(f) Prohibition on declaration of dividend: The Act by virtue of Section 123 (6) specifically
provides that a company which fails to comply with the provisions of section 73 (Prohibition
on acceptance of deposits from public) and section 74 (Repayment of deposits, etc., accepted
before the commencement of this Act) shall not, so long as such failure continues, declare
any dividend on its equity shares.

(g) Interim Dividend:: According to section 123(3), the Board of Directors of a company may
declare interim dividend during any financial year out of the surplus in the profit and loss
account and out of profits of the financial year in which such interim dividend is sought to be
declared

(ii) Punishment for failure to distribute dividends (Section 127):-A new section 127 of the Companies
Act, 2013 came into force on 12th September, 2013 which provides for punishment for failure to
distribute dividend on time. According to this section:

(a) Where a dividend has been declared by a company but has not been paid or the warrant in
respect thereof has not been posted within thirty days from the date of declaration to any
shareholder entitled to the payment of the dividend, every director of the company shall, if
he is knowingly a party to the default, be punishable with imprisonment which may extend to
two years.
(b) He shall also be liable for a fine which shall not be less than 1,000 rupees for every day during
which such default continues.

(c) The company shall also be liable to pay simple interest at the rate of 18% p.a. during the
period for which such default continues.

(d) However, the following are the exceptions under which no offence shall be deemed to have
been committed:
where the dividend could not be paid by reason of the operation of any law;
where a shareholder has given directions to the company regarding the payment of the
dividend and those directions cannot be complied with and the same has been
communicated to him;
where there is a dispute regarding the right to receive the dividend;
where the dividend has been lawfully adjusted by the company against any sum due to it
from the shareholder; or

Where, for any other reason, the failure to pay the dividend or to post the warrant within
the period under this section was not due to any default on the part of the company.

(iii) Unpaid or Unclaimed Dividend (Section 205A of the Companies Act, 1956):-
Where a dividend has been declared by a company but has not been paid, or claimed within thirty
days from the date of the declaration, to any shareholder entitled to the payment of the dividend, the
company shall, within seven days from the date of expiry of the said period of thirty days, transfer the
total amount of dividend which remains unpaid or unclaimed within the said period of thirty days, to a
special account to be opened by the company in that behalf in any scheduled bank, to be called
Unpaid Dividend Account of Company
Where the default is made in transferring the unpaid or unclaimed amount of dividend to the unpaid
dividend account of the company, the company shall, from the date of such default, pay interest, at
the rate of 12% per annum. Any money transferred to the unpaid dividend account of a company
which remains unpaid or unclaimed for a period of seven years from the date of such transfer shall be
transferred by the company to the Investor Education and Protection Fund. If a company fails to
comply with any of the requirements of this section, the company, and every officer of the company
who is in default, shall be punishable with fine which may extend to Rs. 5000 for every day during
which the failure continues.

6. Dividend Payment Models:

Models:-

(i) Walter Model:-

(ii) Gordon Model: - Another theory which contends that dividends are relevant is the Gordons'
model. This model explicitly relates the market value of the firm to dividend policy. It is based on the
following assumptions:
The firm is an all equity firm, and it has no debt.
No external financing is used and investment programmes are financed exclusively by
retained earnings.
The internal rate of return, r, of the firm is constant.
The appropriate discount rate, ke, for the firm remains constant.
The firm has perpetual life.
The retention ratio, b, once decided upon, is constant. Thus, the growth rate, g = br, is also
constant.
The discount rate is greater than the growth rate, ke> br.

Myron Gordon argues that what is available at present is preferable to what may be available in the
future. As investors are rational, they want to avoid risk and uncertainty. They would prefer to pay a
higher price for shares on which current dividends are paid. Conversely, they would discount the value
of shares of a firm which postpones dividends. The discount rate would vary with the retention rate.
The relationship between dividend and share price on the basis of Gordon's formula is shown as:

Po = d0 (1 +g) or Po = d1_____ or Po = E1(1-b)

Ke g Ke g Ke br

(iii) Modigliani and Miller (MM) Hypothesis:-

Modigliani and Miller Hypothesis is in support of the irrelevance of dividends. Modigliani and Miller
argue that firms dividend policy has no effect on its value of assets and is, therefore of no
consequence i.e. dividends are irrelevant to shareholders wealth. According to them, Under
conditions of perfect capital markets, rational investors, absence of tax discrimination between
dividend income and capital appreciation, given the firm's investment policy, its dividend policy may
have no influence on the market price of shares.
The hypothesis is based on the following assumptions:
 The firm operates in perfect capital markets in which all investors are rational and
information is freely available to
There are no taxes. Alternatively, there are no differences in the tax rates applicable to capital
gains and dividends.
The firm has a fixed investment policy.
There are no floatation or transaction costs.
Risk of uncertainty does not exist. Investors are able to forecast future prices and dividends
with certainty, and one discount rate is appropriate for all securities and all time periods.
Thus, r = k = kt for all t.

MM Hypothesis is primarily based on the arbitrage argument. Through the arbitrage process, the MM
Hypothesis discusses how the value of the firm remains same whether the firm pays dividend or not. It
argues that the value depends on the earnings of the firm and is unaffected by the pattern of income
distribution. Suppose, a firm which pays dividends will have to raise funds externally to finance its
investment plans, MM's argument, that dividend policy does not affect the wealth of the shareholders,
implies that when the firm pays dividends, its advantage is offset by external financing. This means that
the terminal value of the share declines when dividends are paid. Thus, the wealth of the shareholders
- dividends plus terminal price - remains unchanged. As a result, the present value per share after
dividends and external financing is equal to the present value per share before the payments of
dividends. Thus, the shareholders are indifferent between payment of dividends and retention of
earnings.

Steps to prove MM theory

1. Compute P1 :- P1=P0(1+k)-D1
2. Compute Money Available:- Retained earnings =PAT- Dividend (nD1))
3. Compute Money Required= Investment (I) Retained Earnings
4. No. of shares to be issued (m)= Money Required
P1
5. Value= (m+n) * P1

Where,
Po = The prevailing market price of a share
Ke = The cost of equity capital
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one.
, n = Number of shares outstanding at the beginning of the period
m= New shares to be issued.
I = Total investment amount required for capital budget
7. Bonus Shares