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Dividend Decision : Part 1

1.1 Dividend Decision:

Meaning and Forms of Dividend,

Factors determining Dividend Policy,
Types of Dividend Policy

The financial decision relates to the disbursement of profits back to investors

who supplied capital to the firm. The term dividend refers to that part of profits
of a company which is distributed by it among its shareholders. It is the reward
of shareholders for investments made by them in the share capital of the
company. The dividend decision is concerned with the quantum of profits to be
distributed, to retain all the profits in business or to keep a part of profits in the
business and distribute among the shareholders . The higher rate of dividend
may raise the market price of shares and thus, maximise the wealth of
shareholders. The firm should also consider the question of dividend stability,
stock dividend (bonus shares) and cash dividend.
It is crucial for the top management to determine the portion of earnings
distributable as the dividend at the end of every reporting period. A company’s
ultimate objective is the maximisation of shareholders wealth. It must,
therefore, be very vigilant about its profit-sharing policies to retain the faith of
shareholders. Dividend payout policies derive enormous importance by virtue of
being a bridge between the company and shareholders for profit-sharing.
Without an organised dividend policy, it would be difficult for the investors to
judge the intentions of the management.
The Dividend Policy is a financial decision that refers to the proportion of the
firm’s earnings to be paid out to the shareholders. Here, a firm decides on the
portion of revenue that is to be distributed to the shareholders as dividends or to
be ploughed back to the firm.
A few basic dividend policies which firms generally pursue are mentioned
below:

Constant Percentage of Earnings:

As per this policy, the firm pays a dividend at a fixed rate on the paid-up share
capital. If this policy is pursued, the shareholders are sure on the earnings on

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their investment. This policy of paying dividend at a constant rate will not
create any problem in those years in which the company is making steady profit.
But paying dividend at a constant rate may face the trouble in the year when the
company fails to earn the steady profit. Therefore, some of the experts opine
that the rate of dividend should be maintained at a lower level if thus policy is
followed. For example, if a company decides to give 5% of its earnings as
dividends, and it earns ₹100 this year, the shareholders will get ₹5. But if next
year it earns ₹50, the shareholders will get ₹2.50.
Stable rate of dividend
Under this policy, a firm pays a fixed dividend to the shareholders. In the firm is
earning higher profits it pays extra dividends over and above the regular
dividend. When the normal condition returns, the firm begins to pay normal
dividends by cutting down the extra dividends. It’s like a company promising to
give ₹10 per share every year. This is good for shareholders, as they know what
to expect each year.
Residual Dividend Policy:
In this type, the company uses its earnings to pay for its expenses, investments,
and savings. Whatever money is left (residual) is given as dividends. This
means the dividend amount can change yearly, depending on the company’s
expenses and earnings.
Each policy has its own pros and cons. The company picks a policy based on its
goals, its finances, and what its shareholders want.
No Dividend Policy
Under the no dividend policy, the company does not distribute dividends to
shareholders. This is because profit earned is retained and reinvested into the
business for future growth. Companies that have a no dividend policy are
constantly growing. Investors invest in them because the value of the company
shares appreciate. Investor prefers the share appreciation to a dividend payout.

Objects of dividend Decisions

Evaluation of Price Sensitivity

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Companies chosen by investors for its regularity of dividend must have a more
stringent dividend policy for maintaining stock prices.
Cash Requirement
The financial manager must consider the capital fund requirements while
framing a dividend policy. Generous distribution of dividend in capital-intensive
periods may put the company in financial distress.
Stage of growth
Dividend decision must be in line with the stage of the company -infancy,
growth, maturity & decline. Each stage undergoes different conditions and
therefore calls for different dividend decisions.
Types of Dividends
Dividends are a portion of a company’s earnings distributed to its shareholders
as a return on their investment. There are various types of dividends that
companies can choose to declare based on their financial condition, profitability,
and strategic goals.
The type of dividends a company chooses to issue depends on various factors
including its financial condition, growth strategy, and shareholder preferences.
Dividends play an important role in attracting and retaining investors, providing
them with a tangible return on their investment and influencing the overall
perception of the company’s financial health and stability.
Cash Dividends
Cash Dividends are the most traditional form of dividends, where shareholders
receive cash payments directly from the Company’s profits.
Significance: Provides shareholders with liquidity, allowing them to receive a
direct monetary return on their investment.
Stock Dividends
Stock dividends involve the distribution of additional shares of the company’s
to existing shareholders, proportional to their current share holdings.
Property dividends

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Property dividends involve distribution of the company’s physical assets instead

of cash or shares. Example: real estate to antiques and can even include
intangible assets such as patents or copyrights.
Significance: Typically occurs when a company has valuable assets that can be
distributed to shareholders, providing them with ownership in those assets
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 an IT firm pays its shareholders 10% of its profits as
property dividends. The value of its property is Rs 500 crores. Each shareholder
will receive an additional asset worth Rs 50 Lakhs INR (500 Cr x 0.10).
Scrip dividends
Scrip dividends are like 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 shareholders can choose between receiving cash or additional shares.
Significance: The shareholders have the flexibility to choose their preferred
form of dividend
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 an IT firm decides to pay its shareholders 10% of its profits
as a scrip dividend. Shareholders who opt for this will receive a scrip worth Rs
50 Lakhs INR (500 Cr x 0.10) that can be exchanged for market shares later.
Liquidating dividends
Liquidating dividends are paid out to shareholders when a company is winding
down its operations or selling a business segment , and there isn't enough money
left to pay in cash dividends.

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The advantage of liquidating dividends is that they can provide a return for
shareholders even if the business has failed. On the downside, it typically means
that all remaining assets will be sold off to pay the dividend. The company will
cease to exist ot there will be a change in structure of the business entity.
For example, XYZ an IT firm decides to pay its shareholders 50% of its
remaining assets as a liquidating dividend. This would mean each shareholder
will receive an amount equivalent to Rs 250 Lakhs INR (500 Cr x 0.50) from
the sale of the company's assets but after this XYZ may cease to exist.
Other types
Special dividends
Onetime non-recurring dividends paid when the company makes exceptional
profits or celebrates a special occasion.
Interim Dividends: Dividends paid before preparation of the company’s annual
financial statements. The shareholders receive periodic returns throughout the
year instead of a single payment at the end of the fiscal year.
Regular Dividends
These are paid to shareholders according to a predetermined schedule- quarterly,
half-yearly etc. Boosts investor confidence on account of consistency or receipt
of income.
Dividend Reinvestment Plans (DRIPS)
DRIPs are an equity investment option offered directly from the
company. Instead of receiving dividends directly as cash, the investor's
dividends are directly reinvested in the underlying equity. As the company
issues more shares to shareholders, more shares will become outstanding in the
market. Therefore, shareholders that do not participate in the company’s DRIP
will see their ownership base diluted.
Spin of Dividends
This is the distribution of shares of its subsidiary or a business segment by the
parent company to the existing shareholders. This allows the shareholders to
hold interests in both entities.
Buyback of shares

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Buyback of shares is the repurchasing of own shares by a company from its

existing shareholders. A company can announce a buyback offer either through
a tender offer or through the open market or from odd-lot holders. The buyback
offer price is usually higher than the market price.
It may be beneficial for a company to repurchase its shares because of the
following reasons:
 reducing the cost of capital,
 ownership consolidation,
 preserving stock prices,
 undervaluation, and
 boosting its key financial ratios
Importance of Dividend
Growth and Expansion of Profits
One of the primary benefits of investing in dividend-paying companies is
dividends tend to steadily grow over time. Well-established companies that pay
dividends typically increase their dividend payouts from year to year.
Dividends Are Helpful in Equity Evaluation
Dividends provide continuous, year-to-year indications of a company's growth
and profitability.
Reducing Risk and Volatility
Dividends are a major factor in reducing overall portfolio risk and volatility.
Dividends are a reliable source of Income.
Dividends are tax efficient.
Portfolio expansion
Manage inflation.
Sustainability
Dividend Decision Theories
Importance Of Dividend Policy

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The most important thing about a dividend policy is that it shows shareholders
how stable and profitable a company is. A consistent dividend payout indicates
a company’s solid financial health, which inspires investor confidence.
A consistent dividend distribution improves the company’s standing in the
financial markets. It shows the company’s financial health, attracting a broader
range of potential investors.
A company’s dividend policy is essential to its financial planning. It outlines the
allocation of profits between dividends and retained earnings, facilitating
strategic financial management and growth initiatives in the future.
A stable dividend policy provides investors with a sense of assurance,
particularly in volatile market conditions. It shows how resilient the company is
and how smart its financial management is, even though the economy is
changing.
Factors Affecting a Dividend Policy
The primary factor influencing a dividend policy is the company’s financial
stability and profitability. A company with stable earnings is more likely to
declare dividends as it can meet its financial obligations and invest in future
projects while rewarding its shareholders.
Liquidity Constraints:
The availability of adequate cash reserves is essential for determining dividend
payments. Corporations may opt for lower dividends to maintain operational
efficiency in the face of liquidity constraints.
Shareholder Preferences:
Different shareholders have different preferences regarding dividend income
and capital gains. To meet the needs of all investors, dividend policies need to
be well-balanced.
Market Conditions:
Prevailing market conditions and economic climates significantly influence
dividend policies. Companies may adjust their policies in response to market
fluctuations to maintain investor confidence.
Legal Restrictions:
The legal restrictions that influence dividend policy are as follows:

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• 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
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.
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.
Condition of Capital Market:
When the capital market is comfortable, companies can follow a liberal
dividend policy.
Stability of Earnings:
When a company is making remarkable progress and has stable earnings, a
liberal dividend policy can be followed.
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 favourable interest rate.
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.
Past Dividend Rate:

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While deciding on a dividend policy, managers and the board of directors

should pay attention to the dividend rate in previous years.
Other Factors:
Dividends should be paid out of earned profits only. If there is carry forward of
past losses, then dividend should not be declared till these are set off. Though,
the dividend is usually paid only once in a year to keep the shareholders in high
spirits, interim dividends should also be declared.
Types of Dividend Contd.:
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 are paid out monthly or quarterly. The company's Board of
Directors declares the interim dividend, but the final approval must be given by
the shareholders.
Interim dividends are paid from retained earnings, which includes the profits of
the previous financial years. It is usually not paid out of current year’s profits as
the same will not be fully realized when the interim dividend is declared.
Final Dividend
A final dividend refers to the dividend declared by a company's board of
directors after the company has issued its full-year financial statements. This
amount is calculated after all year-end financial statements are recorded and the
directors are made aware of the company's profitability and financial health.
Procedural Aspects of Dividend Declaration and Payment:
Process for Declaring Dividend
Step 1: The company in a Board Meeting decides on the amount of dividend
that would be declared and paid.

Step 2: Company issues notice of general meeting with intent to declare

dividends.

Step 3: General meeting is conducted and the resolution for declaring dividend
is passed along with record date.

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Dividend to be paid only to the registered holders of shares entitled to Dividend

or to their order or to their bankers.
Preference Shareholders shall be paid Dividend before Dividend is paid to the
equity Shareholders of the company.
Dividend Stripping:
Shareholders and mutual fund investors often receive dividends on their
investments (based on their choices). These dividends are tax-free. And if there
is a long-term capital gains (LTCG), only a concessional LTCG tax 10% applies
on gains above Rs 1 lakh. Smart investors resort to ‘Dividend Stripping’ to avail
maximum tax benefits.
Losses under the head ‘Capital Gains’ can be set off against income from
capital gains.
Investors, in a bid to avail maximum tax benefits from an investment, buy
shares/mutual fund units before the declaration of dividend, post the dividend
declaration they sell the share/unit when its price falls below the purchase price.
This practice is termed as dividend stripping.
As a result of this activity, the investor receives tax-free dividends. But since
the sale made after receiving the dividend is done at a price lower than the
purchase price, it results in a capital loss.
The concept of dividend stripping can be better explained by way of an
example:
Company XYZ makes an announcement that it is going to pay a dividend of Rs.
50 on April 5, 2018.
Rahul purchased the shares of this company on March 26, 2018, when the price
was Rs.180. He purchased a total of 100 shares.
On April 5, 2018, he received a total dividend of Rs.5000.
The price of shares after dividend declaration fell to Rs. 150. Mr A sells the
shares on May 20, 2018, and therefore makes a loss of Rs.3000.
Total benefit enjoyed by Mr A is thus Rs.8000 (exempt dividend income of Rs
5,000 and capital loss of Rs 3,000)
Dividend stripping is not exactly illegal. But it causes a loss to the exchequer.

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