CHAPTER
VII
DIVIDEND POLICY
The
term dividend refers to that part of profit of a company which is
distributed by the company among its, shareholders. It is the reward of the
shareholders for investments made by them in the shares of the company. The
investors are interested in earning the maximum return on their investments,
but the company needs to provide funds to finance to its long – term growth. If
a company pays out as dividend most of what it earns, then for business requirements
and for further expansion it will have to depend upon outside sources of
finance. So a company should, therefore, distribute a reasonable amount as
dividends to its members and retain the rest for its growth and survival.
FORMS OF DIVIDEND
Dividends can
be classified in various forms. Dividends paid in the ordinary course of
business are known as Profit dividends, while dividends
paid out of capital are known as Liquidation dividends. Dividends may
also be classified on the basis of medium in which they are paid:
a. 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.
b. 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.
c. 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.
d. 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 with out affecting the cash position of
the firm. This has been discussed in detail under “Bonus Shares”.
BONUS SHARES
A company can pay bonus to its
shareholders either in cash or in the form of shares. Many times, a company is
not in a position to pay bonus in cash in spite of sufficient profits because
of unsatisfactory cash position or because of its adverse effects on the
working capital of the company. In such cases, if the company so desires and
the articles of association of the company provide, it can pay bonus to its
shareholder in the form of shares by making partly paid shares as fully paid or
by the issue of fully paid bonus shares.
ADVANTAGES OF
ISSUE OF BONUS SHARES
A. Advantages to the company
1. It makes available capital to carry a larger and more profitable
business.
2. It is felt that financing helps the
company to get rid of market influences.
3. When a
company pays bonus to its shareholders, the value of shares and not in cash,
its liquid resources are maintained and the working capital of the company is
not affected.
4. It
enables the company to make use of its profit on a permanent basis and
increases the credit worthiness of the company.
5. It is
the cheapest method of raising additional capital for the expansion of the
business.
6.
Abnormally high rater of dividend can be reduced by issuing bonus shares which
enables a company to restrict entry of new entrepreneurs in to the business and
thereby reduces competition.
7. The
balance sheet of the company will reveal a more realistic picture of the
capital structure and the capacity of the company.
B. Advantages to
investors or shareholders
It is
generally said that an investor gains nothing from the issue of bonus shares.
It is so because the shareholder receives nothing except something additional
share certificates. But his proportionate ownership in the company remains
unchanged.
DISADVANTAGES OF ISSUE OF BONUS SHARES
1. The
issue of bonus shares leads to a drastic fall in the future rate of dividend,
as it is only the capital that increases and not the actual resources of the
company. The earnings do not usually increase with the issue of bonus shares.
Thus, if a company earns a profit of Rs. 2,00,000 against a share capital of
Rs. 5,00,000 and the issue of bonus shares to Rs. 8,00,000 raises the capital
of the company, the rate of dividend falls from 40% to 25%.
2. The fall
in the future rate of dividend results in the fall of the market price of
shares considerably, this may cause unhappiness among the shareholders.
3. The
reserves of the company after the bonus issue decline and leave lesser security
to investors.
BONUS ISSUE (STOCK
DIVIDEND) VS STOCK SPLIT
Stock
dividend means the issue of bonus shares to the existing shareholders of the
company. It amounts to capitalization of earnings and distribution of profits
among the existing shareholders without affecting the cash position of the
firm. Stock split, on the other hand, means reducing the par value of the
shares by increasing the number of shares proportionately, viz; a share of Rs.
100 may be split in to 10 shares of Rs. 10 each. Thus, the two terms are quite
different from each other.
DETERMINENTS OF DIVIDEND POLICY
Introduction: -
Dividend is that
part of portion of profit given to the shareholders of the company. The
management determines dividend given to the shareholders. The management
decides the portion of profit that is given to the members. Every company has
its own dividend policy. The policy relating to the dividend pay out and
earnings retention varies not only from industry to industry but among
companies with in a given industry and with in a company from time to time. When the company wants rapid growth, the
greater the demand for additional funds.
Also,
if the companies have higher profits returns the funds and employ them to earn
higher returns. So there are a number of factors that affect the dividend
policy of the concern.
Factors affecting the Dividend Policy/Determinants of Dividend Policy
The
payment of Dividend involves some legal as well as financial considerations. It
is difficult to determine a general dividend policy, which can be followed by
different concerns, because in the last analysis the dividend decision has to
be taken considering the special circumstances of an individual case. We can
examine some of the general determinants of dividend policy, which are
considered of major importance in a typical business concern.
The
following are some of these important factors, which determine the dividend
policy.
1. Legal Restrictions: -
Legal
restrictions are significant as they provide a frame work with in which
dividend policy is formulated. These provisions require that dividend can be
paid only out of current profits or past profits. The companies’ rules 1975
require a company providing more than 10% dividend to transfer certain
percentage of current years profit to Reserves. In general terms dividend can
be paid only when the firms’ balance sheet shows positive retained earnings.
Companies
Act further provides that dividends cannot be paid out of capital, because it
will amount to reduction in capital adversely, affecting the security of
creditors. Firms that are under going bank repay proceeds are also legally
prevented from paying dividends. Normal dividends cannot exceed accumulated
retained earnings.
2. Nature of Earnings: -
The
amount and trend of earnings is an important aspect of dividend policy. As
dividends can be paid only out of present and past years profit; earnings of
the company fix the upper limits on dividend. The past trends of the companies
earnings should also kept in consideration while making the dividend decision.
The pattern of change in earnings may vary widely among industries and
individual companies are influenced by their operating and financial leverages.
3. Desire and Type of Share holders: -
Board
of director’s desires the policy of dividend deduction; the directors also give
importance to desires of shareholders in the declaration dividends, as they are
representatives of shareholders. Stockholders in higher age brackets would have
a greater preference on current income and stability in dividends over
long-term capital gain. On the other hand a wealthy investor in high income tax
bracket may not benefit in high current income.
4. Nature of Industry: -
Certain
industries have a comparatively steady and stable demand irrespective of the
prevailing economic conditions. For instance, people used to drink liquor both
in boom as well as depression; such firm expects regular earnings and hence can
follow a consistent dividend policy. On the other hand, if the earnings are
uncertain conservative dividend policy, such firms should return a substantial
part of their current earnings during boom period.
5. Age of the Company: -
A
newly established concern has to limit payment of dividend and retain a
substantial part of earnings for financing its future growth and development,
while older companies, which have established sufficient reserves can afford to
pay liberal dividends.
6. Future Financial Requirements: -
Dividend polices is also
determined by fixed capital requirement of the concern. The company should
project the Fixed Capital Requirement and the available source for such capital
should be considered. If companies have highly profitable investment
opportunities it can convince the shareholders of the need for the limitation
dividend to increase the future earnings and stabilize the Finance Position.
7. Dividend and Working Capital Position: -
A
projection of cash inflows and out flows for a longer period will be helpful in
formulating dividend policy. If a company has higher cash requirements and pay
dividend from cash affect adversely. If the company pay dividend and it has to
borrow after some time to replenish working capital, for all practical purpose
it borrows to pay dividend.
8. Governments Economic Policy: -
The
dividend policy of a firm has also to be adjusted to the economic policy of the
govt. The temporary restriction on payment of dividend ordinance was in force
in 1974 and 1975, companies were allowed to pay dividend not more than 33% of
their profits or 12% on the paid up value of shares which ever was lower.
9. Taxation Policy: -
The
taxation policy of the govt. also affects the dividend decision of a firm. A
high or low rate of tax affects the net earnings of company and their by its
dividend policy. The tax position of the shareholders also affects the dividend
policy. If the shareholders are in higher tax bracket; they are interested in
taking their income in the form of capital gains and bonus shares rather than
dividends.
10. Inflation: -
Inflation
acts as constraint in the payments of dividend. Profits are arrived from the
profit & loss a/c on the basis of historical cost have a tendency to the
over stated in times of rise in prices due to over valuation of stock in trade
and write off depreciation on fixed assets at lower rates. As a result when
prices rise, funds generated by depreciation would not be adequate to replace
fixed asset and substantial part of the current earnings retained.
11. Control Objectives: -
When a company pays high
dividend out of its earnings, it may result in the dilution existing
shareholders control and earnings. As in the case of high pay out ratio, the
retained earnings are insignificant and the company will have to issue new
shares to raise funds. New issue of shares increases in the no. of shares and
ultimately causes lower earning per share and reduce their price in market.
12. Requirement of Institutional Investors: -
The institutional
investor like financial institutions, banks, insurance corporations etc usually
favors a regular payment of cash dividends and stipulates their own terms with
regard to payment of dividend on equity shares.
13. Stability of Dividends: -
Stability
of dividends is another important guiding principle in the formulation of
dividend policy. Stability of dividend refers to the payment of dividend
regularly and shareholders prefer payment of such regular dividends.
14. Liquidity Resources: -
The
dividend policy of a firm is also influenced by the availabilities of liquid
resources. If a company does not have liquid resources, it is better to declare
stock dividends i.e. issue of bonus
shares to the existing shareholders. The issue of bonus shares does not affect
the cash position of the concern.
Conclusion
In view of the variety of considerations affecting dividend policy,
it is very difficult to have one dividend policy, which can be considered
completely satisfactory in all respects. The corporate management has to assess
the relative importance of these factors and choose a line of action, which are
maximum advantages
Dividend Decision and Valuation of
Firms / valuation of Shares
The value of the
firm can be maximized if the shareholders wealth is maximized. There are
conflicting views regarding the impact of dividend decision on the valuation of
the firm. According to one school of thought, dividend decision does not affect
the shareholders wealth and hence the valuation of the firm. On the other hand,
according to the other school of thought, dividend decision materially affects
the shareholders wealth and also the valuation of the firm. The two schools of
thoughts can be grouped as;
I.
The Irrelevance concept of Dividend or The Theory
of Irrelevance
II.
The Relevance concept of Dividend or The Theory of
Relevance.
I.
The
Irrelevance concept of Dividend
a. Residual Approach
b. MM Model
a.
Residual Approach
According to this
theory, dividend decision has no effect on the wealth of the shareholders or
the prices of the shares and hence it is irrelevant so far as the valuation of
the firm is concerned. This theory regards dividend decision merely as a part
of financing decision because the earnings available may be retained in the
business for re- investment. But if the funds are not required in the business
or if there is anything balances after re-investment, it may be distributed as
dividends. Thus, the decision to pay dividends may be taken as a residual
decision.
The
theory assumes that investors do not differentiate between dividends and
retentions by the firm. Their basic desire is to earn higher return on their
investment. If there is any profitable investment opportunity, the shareholders
will allow the company to retain the earnings. The firm should retain the
earnings if it has profitable investment opportunities otherwise it should pay
them as dividends.
b. Modigliani & Miller Approach
Modigliani and
Miller have expressed in the most comprehensive manner in support of the theory
of irrelevance. They agree that the dividend policy has no effect on the market
price of the earning capacity of the firm.
As
observed by MM “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 the shares”
Assumptions of MM Hypothesis: -
The
MM hypothesis of irrelevance of dividend is based on the following assumptions:
-
ü
There are perfect capital markets.
ü
Investors behave rationally.
ü
Information about the company is available to
all without any cost.
ü
There are no flotation and transaction cost.
ü
No investor is large enough to affect the market
price of shares.
ü
There are either no taxes or there are no
differences in the tax rates applicable to dividends and capital gains.
ü
The firm has a rigid investment policy
The
Argument of MM: -
The argument given
by MM in support of their hypothesis is that what ever increase in the value of
the firm results from the payments of dividend will be exactly set off by the
decline in the market price of shares because of external financing and their
will be no change in the total wealth of shareholders
For e.g. If a
company having investment opportunities, distributes all its earnings among
shareholders, it will have to raise additional finds from external sources. So
it can either issue new shares or can depend up on creditor ship securities or
loans. This will result in the increase in number of shares or payment of
interest charges. Both of these will result in the result in the decline of EPS
in the future. Thus whatever a shareholder gains on account of dividend payment
is neutralized completely by the fall in the market price of shares due to
decline in expected future earnings per share.
To be more
specific, the market price of a share in the beginning of a period is equal to
the present value of dividends paid at the end of the period plus the market
price of the shares at the end of the period.
i.e. Po =
D1 + P1
----------
1 + ke
P1 = Po (1 + ke) – D1
Po = market price of the share at
the beginning or prevailing market price
P1
= market price / share at the end of the period
D1 =
dividend to be received at the end of the period.
ke = cost of equity
MM
says that investment needed by the firm on account of payment of dividend is
financed out of the new issue of equity shares.
In
such a case, the number of shares to be issued can be computed with the help of
following equations: -
m
= I – E – nD1
------------
P1
Value of the
firm can be ascertained with the help of the following formula: -
nPo = (n + m) P1 –(I-E)
---------------------
1 + ke
m = number of
shares to be issued I = investment
required
E = total
earnings of the firm during the period
P1 = market
price per share at the end of the period
n = number of
shares outstanding at the beginning of the period.
D1 = dividend
to be paid at the end of the period
nPo = value of
the firm
MM also argues that, if a
company retains earnings instead if giving it out as dividends, the shareholder
enjoys capital appreciation equal to the amount of earnings retained. If it
distributes earnings by way of dividend, shareholders enjoy dividends equal in
value to the amount by which his capital would have appreciated if the company
chosen to retain its earnings. Hence, the division of earnings between
dividends and retained earnings is irrelevant from the point of view of
shareholders.
Criticism of MM Approach
MM hypothesis has been
criticized on account of various unrealistic assumptions as given below;
- Perfect capital market does not exist in reality.
- Information about the company is not available to all persons.
- The firms have to incur flotation cost while issuing securities.
- Taxes do exist and there is normally different tax treatment for dividends and capital gains.
- The investors have to pay brokerage, fees etc, while doing any transaction.
- Shareholders may prefer current income as compared to further future gains.
THEORY OF RELEVANCE
According
to this school of thought on dividend decision, the dividend decisions
considerably affect the value of the firm. The advocates of this school of
thought include Myron Gordon, Jone Linter, James Walter and Richardson.
According to them dividends communicate information to the investors about the
firm’s profitability and hence dividend decisions become relevant. Those firms,
which pay higher dividends, will have greater value as compared to those, which
do not pay dividends or have a lower dividend payout ratio.
- Walter’s
Approach
Prof. Walter’s approach
supports the doctrine that dividend decisions are relevant and affect the value
of the firm. The relationship between internal rate of return earned by the
firm and its cost of capital is very significant in determining the dividend
policy to sub serve the ultimate goal of maximizing the wealth of the
shareholders.
Assumptions of Walter’s Model
i. The investments of the firm are
financed through retained earnings only and the firm does not use external
sources of funds.
ii. The internal
rate of return (r) and cost of capital (k) of the firm are constant.
iii. Earnings
and dividends do not change while determining the value.
iv. The firm
has a very long life
Prof. Walter’s model is
based on the relationship between the firm’s return on investment (r) and the
cost of capital or the required rate of return (k)
If r > k
i.e. if the firm earns a higher rate of return on its investment than the
required rate of return, the firm should retain the earnings. Such firms are
termed as growth firms and the optimum pay out would be zero in this case. This
would maximize the value of shares.
If r < k,
the shareholders would stand to gain if the firm distributes its earnings as
dividend. r < k i.e. r will be
less than k only in case of declining
firms. For such firms the optimism pay out would be 100%, and the firm should
distribute the entire earnings as dividend.
In case if normal firms
where r = k, the dividend policy
will not affect the market value of shares. For such firms there is no optimum
dividend pay out and the value of the firm would not change with the change in
dividend rate.
Prof. Walter has been the
following formula to ascertain the market price of a share: -
P = D + r/ke (E - D)
-------------------
ke
i.e. P = market
price per share
D = dividend per share
r = internal rate of return
E = EPS
ke = cost of equity
Criticism of Walter’s Model
i. The basic
assumption that investors are financed through retained earnings only is seldom
true in real world. Firms do raise funds by external financing.
ii. ‘r’ does
not remain constant.
iii. The
assumption that k (cost of capital) will remain constant also does not hold
well.
- Gordon’s
Approach
Myron
Gordon has also developed a model on the lines of Prof. Walter suggesting that
dividends are relevant and the dividend decision of the firm affects its value.
Assumptions
ü
The firm is an all equity firm
ü
No external financing is available or used.
Retained earnings represent the only source of financing investment programs.
ü
The rate of return on the firm’s investment r is constant.
ü
The retain ratio (b) once decided upon is
constant. Thus, the growth rate of the firm g = br, is also constant.
ü
The cost of capital of the firm remains constant
and it is greater than the growth rate, i.e. k > br
ü
The firm has a perpetual life
ü
Corporate taxes do not exist
According to
Gordon, the market value of a share is equal to the present value of future
stream of dividends. i.e.
P = D1 D2
D3 Dt
-------
+ ------- + --------
+ - - - - - - - - - - - - - +
-------
(1 + k) (1 + k)2 (1 + k) 3 (1
+ k)t
i.e. P = E (1 - b)
-----------
ke – g
P = price of
a share
E = EPS
B =
retention ratio
br = g = growth rate
D = dividend
per share
The implications
of Gordon’s basic valuation model may be summarized as below: -
Ø
When the rate of return of a firm is greater
than the require rate of return (i.e. r>k), the price per share increases as
the dividend payout ratio decreases. Thus, growth firm should distribute
smaller dividends and should retain maximum earnings.
Ø
When r =
k, the price per share remains unchanged and is not affected by the
dividend policy. Thus, for a normal firm there is no optimum dividend payout.
Ø
When r
< k, the price per share increases as the dividend payout ratio
increases. Thus, the shareholders of declining firm stand to gain if the firm
distributes its earnings. For such firms the optimum payout would be 100%.
Gordon’s Revised Model
In
the revised model Gordon suggested that even when r = k, dividend policy affects the value of shares on account of
uncertainty of future, shareholders discount future dividends at a higher rate
than they discount near dividends. As the investors are rational and as they
want to avoid risk, they prefer near dividends than future dividends. This
argument is desired to bird – in the hand argument i.e., the value of a rupee
of dividend income is more than the value of rupee of capital gain.
If two stocks with identical
earnings, record, prospects, but one paying a larger dividend than the other,
then the stock that receives higher dividend will have higher price because the
shareholders prefer present to future values.
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