DIVIDEND

POLICY
Dr. Mohit Pathak
 OBJECTIVE OF DIVIDEND
POLICY
▪ Net earning is divided into two parts:
▪ Dividend
▪ Retained Earning

▪ Retained earnings provide funds to finance the firm’s long-term growth.

▪ Dividends are paid in cash.
▪ The firm that intends to pay dividends also needs to finance its investment opportunities and
will have to use external sources of financing such as:
▪ Debt or
▪ Equity

▪ Thus, the dividend policy has effect on both

▪ Long-term financing and
▪ Wealth of the shareholder
 FIRM’S NEED FOR FUND
(RESIDUAL DECISION)
▪ Dividend to be paid only if the firm does not have profitable investment opportunities.
▪ External equity can be raised, but retained earning is preferred as it is cheaper due to no
transactional cost.
▪ Dividend distribution tax is also paid by companies. Thus, the firms have more funds to invest
than what shareholders could invest if they received dividends.
 SHAREHOLDERS’ NEED FOR
INCOME
▪ Since the capital market is not perfect. Therefore, the shareholders are not indifferent between
dividends and retained earnings.
▪ When the market is uncertain, the shareholders prefer near dividends to future dividends and
capital gains.
▪ Thus, the payment of dividends has a significant impact on the share prices of a company.
▪ Higher dividends may increase the share price and vice-versa.
▪ It is believed by some that in times of uncertainty, to maximise wealth, the firm should pay
dividends to satisfy shareholders.
▪ Investors in high tax brackets prefer capital gains instead of dividends.
▪ The wealth is maximised if the firm retains instead of distributing the profit.
 SHAREHOLDERS’
PREFERENCE
▪ Legally, the board of directors has the discretion to decide the distribution of the company’s
earnings.
▪ Shareholders are the legal owners of the company, and they appoint the board of directors as
their agents.
▪ Therefore, directors should give importance to the shareholders’ expectations in dividend
decisions.
▪ The ownership concentration may define the shareholders’ expectations.
 CLOSELY HELD COMPANY
▪ It refers to a business entity where a small number of shareholders or owners hold a significant
majority of the company's shares.
▪ In such companies, the ownership is concentrated among a few individuals, families, or
entities, often the original founders or a select group of investors.
▪ The body of shareholders is small and homogeneous, and management knows about the
expectations of the shareholders.
▪ Therefore, it is easy to develop a dividend policy.
▪ Eg: If shareholders are in a high tax bracket, the company can establish a dividend policy of
paying sufficient dividends and retaining the rest.
 WIDELY HELD COMPANY
▪ It refers to a business entity where ownership is distributed among a large number of shareholders, and no
single individual or small group of individuals holds a controlling interest in the company.
▪ As the number of shareholders is very large, they are dispersed and may have diverse desires regarding
dividends and capital gains.
▪ It is not possible for such companies to follow a dividend policy that equally satisfies all the shareholders.
▪ The company may follow a dividend policy that serves the purpose of the dominating group but does not
completely neglect the desires of others.
▪ The shareholders in such companies can be divided into four groups:
▪ Small shareholders – Income+Wealth
▪ Retired and old persons - Income
▪ Wealthy investors - Wealth
▪ Institutional investors – Profitable Investment with cash dividend
▪ The policy, once established, should be continued for a long period of time as it helps in creating a particular
kind of clientele.
 CONSTRAINTS ON PAYING
DIVIDENDS
1. Legal Constraints
▪ The directors are not legally compelled to declare the dividend.
▪ However, the central government is empowered to allow any company to pay dividends if it is
in the interest of the public.
▪ The dividend has to be paid in cash. However, companies can also capitalise the profits or
retained earning to issue bonus shares (stock dividend)
2. Financial Constraints
1. Liquidity
2. Financial condition and borrowing capacity
3. Access to capital market
4. Restriction on loan agreement
5. Inflation
6. Control