DIVIDEND POLICIES AND TYPES

The dividend policy of a company is the decision about the distribution of dividends to its shareholders. A dividend
policy is a financial decision that involves deciding on the dividend payout ratio, the frequency of dividends and should
they pay dividends at all or not. It is drafted by the company’s board of directors and acts as a guideline for distributing
dividends to the investors.

The dividend decision of a firm depends on the profits, investment opportunities in hand, availability of funds, industry
trends in dividend payment, and the company’s dividend payment history.

1. Profits: Dividend payment is made from the profits of the company. If the company has no profits, then the
company won’t be able to pay dividends.
2. Investment opportunities: If the firm has projects that will lead to the expansion and growth of the company,
then the company would prefer retaining back the profits to fund the new projects.
3. Availability of funds: A firm’s availability of funds impacts the dividend decision. If the firm has enough
retained earnings to fund new projects, then they have enough funds to distribute dividends from the current
year’s profits.
4. Industry trends in dividend payment: A company has to keep up with the industry’s dividend payment to
survive. Else the shareholders might liquidate their shares in the company to invest in competitors’ companies.
5. Company’s dividend payment history: A company that is paying regular dividends tends to keep the dividends
stable over the years. They either keep the dividend payout ratio steady or the dividend amount stable.

TYPES :-

Companies follow different patterns for paying out dividends. The patterns depend on the type of
dividend policy chosen by them. There are four different types of dividend policy that companies
usually follow, and they are:

Stable Dividend Policy

A stable dividend policy involves fixing a certain amount of dividend that the shareholders periodically
receive. Even if the company incurs a loss, the amount of dividend does not change.
Regular Dividend Policy
In a regular dividend policy, the company fixes a certain percentage of dividend from the company’s
profits. When the profits are high, the dividend payment will automatically be high. While the profits
are low, the dividend payment will remain low. Experts usually considers this to be the most
appropriate policy for paying dividends and creating goodwill.
Irregular Dividend Policy
In an irregular dividend policy, the dividend payment solely depends on the company’s decision. If the
company decides to pay a dividend to the shareholders, then the shareholders get the dividend. The
decision solely depends on the company’s priorities. If the company has a new project to fund, then it
may decide to retain the profits within the company instead of distributing it.
No Dividend Policy
In no dividend policy, the company always retains the profits and doesn’t distribute them to its
shareholders. Usually, growth-oriented companies follow the no dividend policy. The strategy might
suit companies who aim for growth. However, it may discourage investors who are looking for
sustainable income in the long term.
 ISSUES IN DIVIDEND POLICIES

In theory, the objective of a dividend policy should be to maximize a shareholder’s return so that the value of his
investment is maximized. Shareholders’ return consists of two components: dividends and capital gains. Dividend
policy has a direct influence on these two components of return. Dividend Theory Highlight the issues of dividend
policy Critically evaluate why some experts feel that dividend policy matters Discuss the bird-in-the-hand argument
for paying current dividends Explain the logic of the dividend irrelevance Identify the market imperfections that
make dividend policy relevant Understand information content of dividend policy Learning Objectives Let us
consider an example to highlight the issues underlying the dividend policy. Payout ratio—which is dividend as a
percentage of earnings or dividend per share as a percentage of earnings per share—is an important concept vis-à-vis
the dividend policy. Retention ratio is 100 per cent minus payout percentage. Suppose two companies, Low Payout
Company and High Payout Company, both have a return on equity (ROE) of 20 per cent. Assume that both companies’
equity consists of one share each of `100. High Payout Company distributes 80 per cent while Low Payout Company
distributes 20 per cent of its earnings as dividends. As you may recall, growth rate is the product of return on equity
(ROE) times retention ratio :

Growth= ROE x Retention ratio

g = ROE x b

For Low Payout Company, the growth rate is:

g = × 0 2. . 0 0 80 = 0 1. 6 or 16%

For High Payout Company the growth rate will be:

g = × 0 2. . 0 0 20 = 0 0. 4 or 4%

It may be seen from Table 1 that High Payout’s dividend is initially four times that of Low Payout’s.
Walter’s model
 M.M. HYPOTHESIS

According to Miller and Modigliani (MM), under a perfect market situation, the dividend policy of a firm is irrelevant,
as it does not affect the value of the firm.16 They argue that the value of the firm depends on the firm’s earnings that
result from its investment policy. Thus, when investment decision of the firm is given, dividend decision—the split of
earnings between dividends and retained earnings—is of no significance in determining the value of the firm.

A firm, operating in perfect capital market conditions, may face one of the following three situations regarding the
payment of dividends:

 The firm has sufficient cash to pay dividends.

 The firm does not have sufficient cash to pay dividends, and therefore, it issues new shares to finance the
payment of dividends.
 The firm does not pay dividends, but shareholders need cash.

In the first situation, when the firm pays dividends, shareholders get cash in their hands, but the firm’s assets reduce
(its cash balance declines). What shareholders gain in the form of cash dividends, they lose in the form of their claims
on the (reduced) assets. Thus, there is a transfer of wealth from shareholders’ one pocket to another pocket. There is
no net gain or loss. Since it is a fair transaction under perfect capital market conditions, the wealth of shareholders will
remain unaffected. In the second situation, when the firm issues new shares to finance the payment of dividends, two
transactions take place. First, the existing shareholders get cash in the form of dividends, but they suffer an equal
amount of capital loss since the value of their claim on assets reduces. Thus, the wealth of shareholders does not
change. Second, the new shareholders part with their cash to the company in exchange for new shares at a fair price
per share. The fair price per share is the share price before the payment of dividends less dividend per share to the
existing shareholders. The existing shareholders transfer a part of their claim (in the form of new shares) to the new
shareholders in exchange for cash. There is no net gain or loss. Both transactions are fair, and thus, the value of the
firm will remain unaltered after these transactions. In the third situation, if the firm does not pay any dividend a
shareholder can create a home-made dividend by selling a part of his/her shares at the market (fair) price in the capital
market for obtaining cash. The shareholder will have less number of shares. He or she has exchanged a part of the
claim on the firm to a new shareholder for cash. The net effect is the same as in the case of the second situation. The
transaction is a fair transaction, and no one loses or gains. The value of the firm remains the same, before or after
these transactions.
 FORMS OF DIVIDENDS

The usual practice is to pay dividends in cash. Other options are payment of the bonus shares (referred to as stock dividend in USA) and shares
buyback. In this section, we shall also discuss share split. The share (stock) split is not a form of dividend; but its effects are similar to the
effects of the bonus shares.

Cash Dividend

Companies mostly pay dividends in cash. A company should have enough cash in its bank account when cash dividends are declared. If it does
not have enough bank balance, arrangement should be made to borrow funds. When the company follows a stable dividend policy, it should
prepare a cash budget for the coming period to indicate the necessary funds, which would be needed to meet the regular dividend payments
of the company. It is relatively difficult to make cash planning in anticipation of dividend needs when an unstable policy is followed. The cash
account and the reserve account of a company will be reduced when the cash dividend is paid. Thus, both the total assets and the net worth of
the company are reduced when the cash dividend is distributed. The market price of the share drops in most cases by the amount of the cash
dividend distributed.

Bonus Shares

An issue of bonus shares is the distribution of shares free of cost to the existing shareholders. In India, bonus shares are issued in addition to
the cash dividend and not in lieu of cash dividend. Hence companies in India may supplement cash dividend by bonus issues. Issuing bonus
shares increases the number of outstanding shares of the company. The bonus shares are distributed proportionately to the existing
shareholder. Hence there is no dilution of ownership. For example, if a shareholder owns 100 shares at the time when a 10 per cent (i.e., 1:10)
bonus issue is made, she will receive 10 additional shares. The declaration of the bonus shares will increase the paidup share capital and
reduce the reserves and surplus (retained earnings) of the company. The total net worth (paid-up capital plus reserves and surplus) is not
affected by the bonus issue. In fact, a bonus issue represents a recapitalization of reserves and surplus. It is merely an accounting transfer from
reserves and surplus to paidup capital.

Advantages of Bonus Shares

the bonus shares do not affect the wealth of the shareholders. In practice, however, it carries certain advantages both for the shareholders
and the company.

Shareholders The following are advantages of the bonus shares to shareholders:

Tax benefit One of the advantages to shareholders in the receipt of bonus shares is the beneficial treatment of such dividends with regard to
income taxes. When a shareholder receives cash dividend from the company, this is included in his ordinary income and taxed at ordinary
income tax rate. But the receipt of bonus shares by the shareholder is not taxable as income. Further, the shareholder can sell the new shares
received by way of the bonus issue to satisfy his desire for income and pay capital gain taxes, which are usually less than the income taxes on
the cash dividends. The shareholder could sell a few shares of his original holding to derive capital gains. But selling the original shares are
considered as a sale of asset by some shareholders. They do not mind selling the shares received by way of the bonus shares as they consider
it a windfall gain and not a part of the principal. Note that in India as per the current law, investors do not pay any taxes on dividends but they
have to pay tax on capital gains. Hence, the Indian law makes bonus shares less attractive than dividends.

Indication of higher future profits The issue of bonus shares is normally interpreted by shareholders as an indication of higher profitability.
When the profits of a company do not rise, and it declares a bonus issue, the company will experience a dilution of earnings as a result of the
additional shares outstanding. Since a dilution of earnings is not desirable, directors usually declare bonus shares only when they expect rise in
earnings to offset the additional outstanding shares. Bonus shares, thus, may convey some information that may have a favourable impact on
the value of the shares. But it should be noticed that the impact on value is that of the growth expectation and not the bonus shares per se.

Future dividends may increase If a company has been following a policy of paying a fixed amount of dividend per share and continues it after
the declaration of the bonus issue, the total cash dividends of the shareholders will increase in the future. For example, a company may be
paying a `1 dividend per share and pays 1:1 bonus shares with the announcement that the cash dividend per share will remain unchanged. If a
shareholder originally held 100 shares, he will receive additional 100 shares. His total cash dividend in future will be `200 (`1 × 200) instead of
`100 (`1 × 100) received in the past. The increase in the shareholders’ cash dividend may have a favourable effect on the value of the share. It
should be, however, realized that the bonus issue per se has no effect on the value of the share; it is the increase in earnings from the
company’s invests that affects the value.
STABILITY IN DIVIDENDS DETERMINANTS