Module 6

Dividend Policy
Prepared and presented by
Ms. Swati Abhang
Contents
• Meaning and Importance of Dividend Policy
• Factors Affecting an Entity‘s Dividend Decision,
• Overview of Dividend Policy Theories and Approaches,
• Gordon‘s Approach,
• Walter‘s Approach ,
• Modigliani-Miller Approach.
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.
What is a Dividend?
• A dividend is the share of profits that is distributed to shareholders in the
company and the return that shareholders receive for their investment in
the company.
• The company’s management must use the profits to satisfy its various
stakeholders, but equity shareholders are given first preference as they
face the highest amount of risk in the company.
• A few examples of dividends include:
• 1. Cash dividend
A dividend that is paid out in cash and will reduce the cash reserves of a company.
• 2. Bonus shares
Bonus shares refer to shares in the company are distributed to shareholders at no
cost. It is usually done in addition to a cash dividend, not in place of it.
Examples of Dividend Policies
• 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
• 2. Stable dividend policy
• 3. Irregular dividend policy
• 4. No dividend policy
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 a 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 is 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 Affecting Dividend Policy
• Management, working with the board of directors, must determine the best
uses for a company’s cash. From a high level, a company has 2 options for
its cash:
• Retain it
• Pay it to shareholders
• If they decide to retain it, they have several more options to
consider. Specifically, they can
• Increase cash reserves or other liquid investments
• Reinvest back into the business
• Acquire another company
• Pay off debt
• Buyback shares of their stock
• All of these competing options for the use of cash are factors affecting
dividend policy.
• For example, a company may have large amounts of debt. Furthermore, its
debt agreements may limit the dividends it can pay.
Factors Affecting Dividend Policy
• Amount of Earnings
Dividends are paid out of current and past earnings. Thus, earnings is a major
determinant of dividend decision.
• Stability in Earnings
A company having higher and stable earnings can declare higher dividends
than a company with lower and unstable earnings.
• Stability of Dividends
Generally, companies try to stabilize dividends per share. A steady dividend is
given each year. A change is only made, if the company’s earning potential has
gone up and not just the earnings of the current year.
• Growth Opportunities
Companies having good growth opportunities retain more money out of their
earnings so as to finance the required investment. The dividend declared in
growth companies is, therefore, smaller than that in the non-growth
companies. .
 Factors Affecting Dividend Policy
• Cash Flow Position
Dividend involves an outflow of cash. Availability of enough cash is necessary for
payment or declaration of dividends.
• Shareholders’ Preference
While declaring dividends, management must keep in mind the preferences of the
shareholders. Some shareholder& general desire that at least a certain amount is paid
as dividend. The companies should consider the preferences of such shareholders .
• Taxation Policy
If the tax on dividends is higher, it is better to pay less by way of dividends. But if the
tax rates are lower, higher dividends may be declared. This is because as per the
current taxation policy, a dividend distribution tax is levied on companies. However,
shareholders prefer higher dividends, as dividends are tax free in the hands of
shareholders.
• Stock Market Reaction
Generally, an increase in dividends has a positive impact on stock market, whereas, a
decrease or no increase may have a negative impact on stock market. Thus, while
deciding on dividends, this should be kept in mind.
Factors Affecting Dividend Policy
• Access to Capital Market
Large and reputed companies generally have easy access to the capital
market and, therefore, may depend less on retained earnings to finance
their growth. These companies tend to pay higher dividends than the
smaller companies.
• Legal Constraints
Certain provisions of the Companies Act, place restrictions on payouts as
dividend. Such provisions must be adhered to, while declaring the
dividend.
• Contractual Constraints
While granting loans to a company, sometimes, the lender may impose
certain restrictions on the payment of dividends in future. The companies
are required to ensure that the dividend payout does not violate the terms
of the loan agreement in this regard.
Types of Dividend
1. Equity Dividend:
• The dividend paid on equity shares is called Equity Dividend. The rate of
equity dividend is set (recommended) by the board of directors of a business
firm and approved by their shareholders.
2. Preference Dividend:
• Preference dividend is paid on Preference Shares. At the time of issue of such
shares, the rate of dividend is mentioned which remains fixed in nature. This
dividend on preference shares is paid before equity dividend. The board of
directors of a business firm does not put any recommendation towards
preference dividend viz. rate, payment mode etc.
3. Interim Dividend:
• Interim dividend is paid by a company for the current year before the accounts
for that period have been closed. Such dividend is paid when the company has
heavy earnings during the year.
Types of Dividend
4. Regular Dividend:
• Payment of dividend at the usual rate is termed as regular dividend. The
investors such as retired persons, widows and other economically weaker
people prefer to get regular dividends.
5. Cash Dividend:
• A cash dividend is a usual method of paying dividends. Payment of dividend in
cash results in outflow of funds and reduces the company’s net worth, though
the shareholders get an opportunity to invest the cash in any manner they
desire. This is why the ordinary shareholders prefer to receive dividends in
cash.
• But the firm must have adequate liquid resources at its disposal or provide for
such resources so that its liquidity position is not adversely affected on account
of cash dividends.
Types of Dividend
6. Stock Dividend:
• Stock dividend means the issue of bonus shares to the existing
shareholders. If a company does not have liquid resources it is better to
declare stock dividend. Stock dividend amounts to capitalization of
earnings and distribution of profits among the existing shareholders
without affecting the cash position of the firm.
7. Scrip or Bond Dividend:
• A scrip dividend promises to pay the shareholders at a future specific date.
In case a company does not have sufficient funds to pay dividends in cash,
it may issue notes or bonds for amounts due to the shareholders. The
objective of scrip dividend is to postpone the immediate payment of cash.
A scrip dividend bears interest and is accepted as a collateral security.
Types of Dividend
8. Property Dividend:
• Property dividends are paid in the form of some assets other than cash. They
are distributed under exceptional circumstances and are not popular in India.
9. Composite Dividend:
• When dividend is paid partly in cash and partly in the form of property then
it is known as composite dividend.
10. Optional Dividend:
• Instead of paying a composite dividend, if the company gives option to its
shareholders either for cash dividend or for property dividend then it is called
option dividend.
11. Extra or Special Dividend:
• Special dividend is an abnormal and non-recurring form of dividend, when
the management of a company does not want to make frequent changes in the
regular rate of dividend but company is having good amount of profits or
undistributed reserves then they can declare extra or special dividend.
Approaches/ models
Gordon’s Model:
• According to Gordon’s Model, the value of the share is given by the
following equation:
2. Walter’s Model:
• Walter’s Dividend model measures the effect of dividend on common
stock value by making a comparison of the actual and normal
capitalization rates i.e. –

• As per Walter’s model the rate of return on investment and cost of

capital determine the price of share. If r > k, the price per share
increases as dividend payout ratio decreases. If r < k the price per share
increases as dividend payout ratio increases. The dividend pay-out ratio
has no effect on the price of the share if r = k.
• Under the circumstance, the optimal pay-out ratio (i) for a growth firm
(r > k) is nil (ii) declining firm (r < k) is 100 percent and (iii) for a
normal firm (r = k) is irrelevant.
 3. Modigliani-Miller Theory:
According to MM approach, the dividend policy of a firm has no effect on the value of the
firm.
This approach is based on certain assumptions which are as follows:
Assumptions:
(a) There are perfect capital markets and investors are rational.
(b) Information is freely available and there are numerous transactions.
(c) An investor cannot influence prices.
(d) Flotation costs are nil.
(e) There are no taxes.
(f) The firm has a fixed investment policy.
(g) Risk of uncertainty does not exist.
Mathematical Proof of MM Approach:
E.g., – A company has a P/E (Price/Earnings) ratio of 10. The amount of share Capital is
Rs. 50,00,000 dividend into shares of Rs. 100 each. The company expects a declaration of
dividend of Rs. 8 per share. On the assumption that the company pays dividend, its net
income is Rs. 5,00,000 and it makes new investments of Rs. 10,00,000 during the period
proven under the MM assumption that the value of the firm remains unchanged when.
(a) Dividends are paid; and
(b) Dividends are not paid
Important Questions
1. Discuss five reasons why a company's dividend policy is crucial for both
shareholders and the company itself. Provide examples to support your points.
2. Differentiate between internal and external factors affecting dividend decisions.
Provide three examples of each type of factor and analyze how they can impact
a company's dividend policy.
3. List and explain different dividend policies.
4. Describe the difference between cash dividends and stock dividends. How does
the choice between these two types of dividends affect a company's financial
position and shareholder wealth?
5. What are the various factors that influence a company's dividend policy? Provide
examples of how these factors can affect dividend decisions in different
industries.
6. Explain the significance of dividend policy in financial management. Discuss
how a firm's dividend decisions can impact its shareholders and overall value.
7. Explain Gordans’s model for dividend policy.
Important Questions
8. Define dividend policy in the context of corporate finance and briefly explain
its significance for shareholders.
9. List two internal factors that can influence a company's dividend decision.
Briefly explain why each factor is significant.
10. List two external factors that can influence a company's dividend decision.
Briefly explain why each factor is significant.
11. Name two prominent theories or approaches related to dividend policy.
Provide a brief description of each theory.
12. State formula for the dividend per share if ABC Corporation distributes all of
its earnings as dividends.
13. Explain the Modigliani-Miller Theory of dividend irrelevance in one or two
sentences.
14. Elaborate Regular dividend policy.
Important Questions
15. Discuss five reasons why a company's dividend policy is crucial for both shareholders
and the company itself. Provide examples to support your points.
16. Differentiate between internal and external factors affecting dividend decisions.
Provide three examples of each type of factor and analyze how they can impact a
company's dividend policy.
17. List and explain different dividend policies.
18. Describe the difference between cash dividends and stock dividends. How does the
choice between these two types of dividends affect a company's financial position and
shareholder wealth?
19. What are the various factors that influence a company's dividend policy? Provide
examples of how these factors can affect dividend decisions in different industries.
20. Explain the significance of dividend policy in financial management. Discuss how a
firm's dividend decisions can impact its shareholders and overall value.
21. Explain Gordans’s model for dividend policy.