7

Dividend and Reserve Policies

Joint Stock Company' is a form of organization in which the

company is financed through equity capital raised from its share holders
They invest in the company with the objective of getting regular
income. They receive this income in the form of dividend. If dividend
is not distributed among members or dividend is less than the
expectations
of the share holders, they will be discouraged for savings and investment.
In this situation it will be very difficult for companies to get additional
capital and it will be impossible for new companies to mobilise capital
from the. primary capital markets. Thus dividend is not only
important
for a company and its members but it is very important for promotion
of national savings and investment. For proper understanding of dividend
policy, it is essential to under stand the meaning of dividend.

MEANING OF DIVIDEND
The Indian companies Act does not define the term Dividend'
but in common sense, dividends are the divisible profits of a company
distributed amongst members in proportion to their shares.
According to S.M. Saha, "Dividends are profits of a trading
company divided amongst members in proportion to their shares."
According to the Supreme Court of India, "Dividend is the
portion of profits of the company which is allocated to the holders of
shares in the company."
It can be concluded that dividends are those profits which have
been allocated to be distributed amongst the shareholders in proportion
to their shares. After declaration dividends are paid to the shareholders
as per the provisions of India Companies Act. Usually a company
distributes dividend amongst shareholders if it earns profus. But here
one thing should be made clear that the share holders have claim over

surpluses of the company but they cannot force the company to declare
and
and distribute dividend. If the company has plans of expansion
and it can
diversification in near future than it will need more finance
 board of directors should
forc-go declaration of dividend. The keep
ka
two points in view while deciding the declaration of dividend
i) Needs of the Company- The financial requirements of tho
company should be estimated and if these need are more urgent than
an
company can avoid dividend declaration and keep all profits as retained
carnings and plough back in busincss.
i) Reasonable Returns to Shareholders-Dividends are earnings
for shareholders and they expect reasonable earnings from their
investments. Therefore company should declare reasonable dividends
regularly and if this does not happen then shareholders are disheartened
and market prices of shares fall.

FORMS OF DIVIDEND
The dividends can be distributed in a number of forms such as:
(i) Cash Dividend-This is the most popular and prevalent form
of dividends. Generally sharcholders prefer cash dividend because it is
very convenient for them. Usually companies with sound liquidity position
distribute dividends in cash.
(ii) Stock Dividend-Stock dividend is popularly know as dividend
in the form of bonus shares. When a company has surplus reserves
but does not have adequate liquidity then the company capitalises its
reserves and distributes these reserves as bonus shares.
(ii) Bond Dividend-When a company is not in a position to
distribute dividend in cash due to liquidity problem then company can
distribute dividend in the form of bonds or debentures payable after
5 to 7 years. Some times company also pays interest on debentures.
Promissory notes can also be issued in lieu of dividend.
(iv) Property Dividend-dividends can be distributed in the form
of property. Some times company doces not possess adequate liquidity
but possess property then the company can distribute dividend in the
form of securities of other companies or government. Likewise the
company can distribute any other divisible asset as dividend. This form
of dividend is not popular in India but in western countries some of
the beverage companies distribute dividend in the form of wine bottles.

(v) Composite Dividend-When a company pays some parl of

dividend in cash and remaining in the form of property, it is called
composite dividend.
(vi) Optional Dividend- When a company gives an option to its
sharcholders to receive dividend either in cash or
kind, then it is called
optional dividend.
 7.3
(vii) Interim Dividend- Usually a
end of a financial company pays dividend at the
year. Some times a company earns
before the close of the financial sufficient profit
year and its management declares
dividend. This dividend is called interim dividend.
(vi) Extra or Special Dividend-There should not be
frequent
changes in dividend rates if a company wants to follow a sound and
stable dividend policy. A company should
keep dividend rate reasonable
and stable. Somet1mes company may earn
extraordinary profits
then
company may pay special dividend besides regular dividend.
(ix) Regular Dividend- By dividend we mean regular dividend
paid annually, proposed by the board of directors and approved by
the shareholders in general meeting. It is also known as find dividend
because it is uscually paid after the finalisation of accounts. It is
generally paid in cash as a percentage of paid-up capital, say 10% or
15% of the capital. Sometimes, it is paid per share. No dividend is
paid on calls in advance or calls in arrears. The company is, however,
authorised to make provision in the articles prohibilitng the payment
of dividend or shares having calls in arrears.
(x) Scrip Dividend-Scrip dividends are used when earnings justify
a dividend, but the each position of the company is temporarily weak.
So, shareholders are issued shares or debentures if other companies
hold by the company às investment. Such payment of dividend is called
Scrip dividend. Shareholding generally do not like such dividend because
the shares or debentures so paid are worth less for the shareholders
as directors would use only such investments which they found where
not good. Such dividend was allowed before passing of the Companies
(Amendment) Act 1960, but thereafter this undealthy practice was
stopped.
But, it is, however, importent to note that in India, distribution
of dividend is permissible in the form of cash or bones shares only.
Distribution of dividend in any other form is not allowed.

MEANING OF DIVIDEND POLICY

Dividend policy is a very flexible and wide word. It is made of
two words: Dividend + Policy. We have explained the meaning of
dividend i.e. it is a part of divisible profits and distributed amongst
shareholders. Policy means practice or principles of working. Theretore

dividend policy is concerned with the determination of dividend amount

and its distribution plan. A company should formulate a sound dividend
policy taking into consideration the amount of past dividend, present
year profits, liquidity position and financial health of the company.
of a company managers do not have
an
While framing dividendpolicy
 Vunagement
option to pay or not to pay dividend but they face the problem
deciding the quantum of dividend. In the words of Weston and Bripha of
"Dividend Policy determines the division of carnings between am,
paymen
ayment
to sharcholders and retained earnings." The action plan for the
distribution of dividend may be called dividend policy. A well
out sound dividend policy should be framed.
thoughtht
BASIC ISSUES INVOLVED IN DIVIDEND POLICY|
There are certain basic questions which are involved in
the sound dividend policy. Such
determining
questions are
1. Cost of Capital. Cost of
capital is one of the
for taking a decision whether to distribute dividend or not. considerations
As a decision
making tool, the Board calculates the ratio of rupee profits the business
expects to earn (Ra) to the rupee profits that the shareholders can
expect to earn outside (Rc) i.e. Ra/Rc. If the ratio is less than one.
it is a signal to distribute dividend and if it
is more than one, the
distribution of dividend will be discontinued.
2.
Realisation of Objectives. The main objectives of the
maximisation of wealth-for firm, i.e.,
shareholders-including current rate of
the
dividend-should also be aimed at in formulating the dividend policy.
3. Shareholders
Group. Dividend policy affects the shareholders
group. It means a company with low pay out and heavy reinvestment
attracts shareholders interested in
capital gains rather than in current
income whereas a company with high dividend
who are interested in current incomne.
pay-out atracts those
4. Relase of
Corporate Earnings. Dividend distribution is taken
as a means of distributing unused funds. Dividend
policy affects the
shareholders wealth by varying its dividend
pay-out ratio. In dividend
policy, the financial manager decide whether to release
corporate
earnings or not.
These are certain basic issues involved in formulating a dividend
policy. Dividend policy to a large extent affects the financial structure,
the flow of funds, liquidity, stock prices and in the last shareholders
satisfaction. That is why management and in the last degree of judgement
in establishin a sound dividend
pattern.
ESSENTIALS OF SOUND DIVIDEND POLICY
A sound dividend policy should possess follqwing elements.
(1) Stability-There should be a regularity in dividend distribution
and the rate of dividend should not be changed very frequently. If a
company pays very high dividend in a year and could not pay dividend
at all in other years, this is not good. On the other hand if a company
 OWCte .
pays moderate dividend it is good because its shareholders will be
happy and there will be no speculation in the share prices of the company.
(2) Gradually Rising Dividend Rates-Every company should try
to increase its dividend rates gradually and slowly. In the days of rising
prices, shareholders expect their income should also rise and for meeting
this expectation the company should raise dividend rates.
3) Distribution of Dividend in Cash-We have discussed in
previous pages various forms of dividend. Usually shareholders prefer
cash dividend so a company should pay dividend in cash. Sometimes
there may be huge reserves or surplus in the company then these can
be capitalise and may be distributed as Bonus Shares.
4) Moderate Start-When a company starts earning the profits
it can declare dividend. The company should start dividend payment
with a moderate rate and it can raise dividend gradually as and when
its profits rise.
(5) Other Factors- Besides the above mentioned basic factors a
company has to keep some other factors in view while deciding dividend
policy. The company should pay dividend after write off all the losses.
Usually dividend should be paid once in a year and if there are more
profits interim dividend may be paid.
FACTORS DETERMINING DIVIDEND POLICY
The dividend policy plays an important role in the financial
decisions, therefore, it should be properly framed. Time to time dividend
policy should be reviewed and necessary changes be made. Here we
can discuss some of the important factors which affect the dividend
policy of a company. Some of such factors are as under
1. Stability of Earnings. The nature of business has an important
bearing on the dividend policy. Industrial units having stability of
earnings may formulate a more consistent dividend policy than those
having an even flow of incomes because they can predict easily their
savings and earnings. Usualy, enterprises dealing in necessities suffer
less from oscillating earnings than those dealing in luxuries or fancy
goods.
2. Age of a Corporation. Age of the corporation counts much in
deciding the dividend policy. A newly-established company may require
much of its earnings for expansion and plant improvement and may
adopt a rigid dividend policy while, on the other hand, an older company
can formulate a clear cut and more consistent policy regarding dividend.
3. Liquidity of funds. Availability of cash and sound financial
position is alsc an important factor in dividend decision. A dividend
of
represents a cash outflow, the greater the funds and the iquidity
7.6
The liquidity of a firm
thefirm, the better the ability to pay dividend.
investment and financial decisions
of the
depends very much on the
of expansion and the manner
firm which in turn determines the rate
dividend will be preferrcd
of financing. If cash position is weak, stock
distribute cash dividend.
and if cash position is good, companycan
of ownership als0 affects
4. Extent of Share Distribution. Nature
is likcly to get the assct
the dividend decisions. A closely helkl company
or for following a
of the sharcholders for the suspension of dividend
a company having a
conservative dividend policy. On the other hand,
distributed and forming low or
good number of sharcholders widely
difficult in securing such
medium income group would face a great
assent because they will emphasise
to distribute higher dividends in

cash immediately.
their
5. Needs for Additional Capital. Companicd rectain a part of
The income may be
profits for strengthening their financial position. of
conserved for meeting the increascd requirements working capital
find difficulties in
or of future expansion. Small companies usually

raising finance for their needs of increased working capital for expansion
programmes. They, having no
other alternative, use their ploughed back
distribute dividend at low rates and retain
profits. Thus, such companies
a big part of profits.
6. Trade Cycles. Business cycles also exercise influence upon
dividend policy. Dividend policy is adjusted according to the business
oscillations. During the boom, produent management creates good
reserves for contingencies. Higher rates of dividend can be used as a
tool for marketing the securities in an otherwise depressed market. The
can be proved and maintained by the companies in
financial solvency
dull years if the adequate reserves have been built up.
7. Government Policies. The earning capacity of the enterprisesis
widely affected by the change in fiscal, industrial, labour, control and
other Government policies. Sometimes, Government restricts the
distribution of dividend beyond a certain precentage in a particular
industry or in all spheres of business activity as was done by the
Government of India in emergency. The dividend policy has to be
modified or formulated accordingly.
8. Taxation Policy. High taxation reduces the earnings ol he
down.
companies and consequently the rate of dividend is lowered
Sometimes Government levies dividend-tax on distribution of dividend
beyond a certain limit. It also affects the rate of capital formation.
9. Legal Requirement. In deciding on the dividend, the directors
take the legal requirements too into consideration. In order to protect
the Companies Act. 190
the interests of creditors and outsiders,
 prescribes certain guidelines in respect of the distribution and payment
of dividend. Moreover, a company is required to provide for
depreciation
on its fixed and tangible assets before declaring dividend on shares. It
proposes that 'dividend should not be distributed out of capital in any
case. Likewise, contractual obligation should
also be fulfilled, for example
payment of dividend on preference shares in priority over ordinary
dividend.
10. Past Dividend Rates. While formulating the dividend
policy,
the directors must keep in mind the dividend paid in past years. The
current rate should be around the average past rate. If it has been
abnormally increased, the shares will be subjected to speculation. In a
new concern, the company should consider the dividend policy of the
rival organisations.
11. Ability to Borrow. Well established and large firms have better
access to the capital market than the new companies and may borrow
funds from other external sources if there arises any need. Such
companies may have a better dividend pay-out ratio. Whereas smaller
firms have to depend on their internal sources and therefore they will
have to built up good reserves by reducing the dividend pay-out ratio
for meeting any obligation requiring heavy funds.
12. Policy of Control. Policy of control is another determining
factor in so far as dividends are concerned. If the directors want to
have control-on company, they would not like to add new shareholders
and therefore, declare a dividend at low rate. Because by adding new
shareholders they fear dilution on control and diversion of policies and
programmes of the existing management. So, they prefer to meet the
needs through retained earnings. If the directors do not bother about
the control of affairs they will follow a liberal dividend policy. Thus
control is an influencing factor in framing the dividend policy.
13. Repayment of Lona. A company having loan indebtedness are
vowed to a high rate of retention earnings, unless some other
arrangements are made for the redemption of debt on maturity. It will
naturally lower down the rate of dividend. Sometimes, the lenders
(mostly institutional lenders) put restriction on the dividend distribution
till such time their loan is outstanding. FormaB loan contracts generaly
provide a certain standard of liquidity and solvency to be maintained.
Management is bound to honour such restrictions and to limit the rate
of dividend pay- out.
14. Time for Payment of Dividend. When should the divided be
of
paid is another consideration. Payment of dividend means outflow
when
cash. It is, therefore, desirable to distribute dividend at a time
t1mes as
it Is least needed by the company because there are peak
 well as lean period of expenditure. Wise management should
Management
payment of dividend in such a manner that there is no cash
in need of outf
at a time when the undertaking is already urgent
15. Regularity and Stability in Dividend
finances,
should be paid regularly because cach investor
Payment. Dividend
is interested in
regular payment of dividend. The management should, in spite of re the
payment of dividend, consider that the rate of dividend should hea
the most constant. For this purpose sometimes companies main. all
Dividend Equalisation Fund.
tain
16. State of Capital Market. If the capital market position
s
comfortable in the country and the funds may be raised from differer
sources without much difficulty, the management may tempt to declare
ierent
a high rate of dividend to attract the investors and maintain the existino
shareholders. Contrarily, if there is a slump in the stock market and
the stockholders are not interested in making the investment in securities
the management should follow a conservative dividend policy by
maintaining a low rate of dividend and ploughing back a sizable portion
of profits to face any contingency. Likewise, t the term lending financiai
institutions advance loans of stiffer terms, it may be desirable to rely
on internal sources of financing, and accordingly conservative devidend
policy should be pursued.
TYPES OF DIVIDEND POLICY
Broadly three types of dividend policies are prevalent in practice.
These are as follows :
(A) Conservative Dividend Policy
A conservative dividend policy is one where financial managers
keep the company interest at top priority and give secondary importance
to the interest of shareholders. In this policy managers plough back
profit in the business and distribute very low dividend amongst members.
This policy is known as conservative or hard dividend policy. Here pay
out ratio is kept either very low or zero. This policy is very good lor
those companies which need more finance for expansion and
and
development. It should not be so conservative that the shareholdes:
are frustrated. It should satisfy their minimum
expectations.
(B) Liberal Dividend Policy
This is just opposite to the conservative dividend poicy. This is
a liberal policy because most of the profits are distributed amos
ngst

shareholders and a very small part is kept in the company as rc i.e.

earnings. The payout ratio may be as high as 90 to 95 per cen
n
Rs. 90 to 95 out of Rs. 100 are distributed
amongst sharehou
this policy present interest of
Over

shareholders is given preferenco

 ESEn
Folicies
theirlong-term interest. The 7.9
shortage of funds for application
of this
policy results eitherin
share prices. It is
expansion and development or speculation
very essential
that this in the
ean keep interest of sharehdlders policy should be such which
and
C) Stable Dividend Policy company protected.
This is the long term
changes
policy
are not made. This
of dividend
distribution where frequent
policy
needs of the company and the gives equal importance to the future
an equal part of profits is
present needs of share holders.
distributed Usually
eaual part is plough back in the business.among shareholders and anan
remains same during the years of Usually rate of dividend
During prosperity more reserves areprosperity and unfavourable
created and used years.
or adverse years. Tò conclude, a stable dividend during normal
Dolicy which 1s not affected by the policy is a long-term
changes in earnings from year to
year.
Stable dividend policy may further be divided into
three categories
(a) Stable Dividend Rate-Under this
policy
company keeps dividend rate stable or fixed. For management
of the
may decide 15% as dividend rate and the same
example management
rate be applied
for years of prosperity and years of recession. This may
in those companies, in which earnings remain stable for policy is followed
a long
A dividend equalisation funds is created and period.
stable dividend rate is maintained.
through its operation
(b) Stable Pay-out Ratio-Under this policy company management
does not fix a stable rate of dividend but a stable
pay out ratio is
fixed. In this policy dividend per share and retained
earnings will change
from year to year with the changes in earnings of the company but
the dividend pay out ratio will remain stable. For
example a company
may fix 60% as pay out ratio. In such a situation whatever is earned
by the company 60%% of it will be distributed amongst shareholders as
dividend and remaining 40% will be kept in the company as retained
earnings.
(c) Regular Plus Extra Dividend-This is another way of stable
dividend policy in which company pays a regular dividend at a moderate
fixed rate but during periods of prosperity some extra dividend is paid
to the shareholders. This extra dividend is paid for a short period.
Tluotw