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DVDP
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Topic:Risk and Uncertainty: Trade Off Return
Course: Business Finance
Group members are;
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Abstract
Dividend policy decisions are concerned with decisions for deciding the amount of
profits a business would like to distribute among their owners and shareholders. These
decisions also involve determining how much amount can be retained within the
business for further operations. Factors affecting dividend decision policies are
(i) Legal constraints: The Companies Act, 1956 has legal provisions under which a
certain percentage of profits should be transferred into reserves if the dividend to be
paid is more than 10 percent.
(ii) Stability of earnings: If the business is able to consistently reduce short-term
liabilities that it will be earning stable earnings continuously to declare more
dividends.
(iii) Access to capital markets: A business has easy access to capital markets for
raising capital if a higher dividend rate is declared
(iv) Taxation policy: Tax policy is directly proportionate to a declaration of dividends.
As it directly influences the amount of profits available with the company to declare
dividends.
Theoretical Foundations:
Key Factors:
Decision Models:
Empirical Evidence:
Practical Implications:
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Dividend policy decision
1.0 INTRODUCTION
Once a company makes a profit, it must decide on what to do with those profits. They could
continue to retain the profits within the company, or they could pay out the profits to the owners of
the firm in the form of dividends. The dividend policy decision involves two questions:
i. What fraction of earnings should be paid out, on average, over time? And,
ii. What type of dividend policy should the firm follow? I.e. issues such as whether it should
maintain steady dividend policy or a policy increasing dividend growth rate etc.
On the other hand, Management has to satisfy various stakeholders from the profit. Out of the
Stakeholders priority is to be given to equity share -holders as they are being the highest risk.
1.1 OBJECTIVE OF THE PAPER
i. What dividend is all about and its types, dividend decision and procedures
ii. The dividend policies, it theories and types
iii. The various models of dividend
iv. Dividend in relation to a firm's life cycle
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v. The measures of dividend that can be used by companies
1.2 DEFINITION OF DIVIDEND
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As per the section 9 (3) of the Company Income Tax Act, dividend defined as: -
a. In relation to a company not being in the process of being wound up or liquidated, any profits
distributed, whether such profits are of a capital nature or not, including an amount equal to
the nominal value of bonus shares, debentures or securities awarded to the shareholders and
b. In relation to a company that is being wound up or liquidated, any profits distributed whether
in money or money's worth or otherwise, other than those of a capital nature earned before or
during the winding up or liquidation.
"The term dividend refers to that portion of profit (after tax) which is distributed among the
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owners/ shareholders of the firm."
"Dividend may be defined as the return that a shareholder gets from the company, out of its profits,
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on his shareholdings."
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In other words, dividend is that part of the net earnings of a corporation that is distributed to its
stockholders. It is a payment made to the equity shareholders for their investment in the company.
Dividend is the payment received by a shareholder from a company after distribution of profit.
Dividend is a reward to equity shareholders for their investment in the company. It is a basic right
of equity shareholders to get dividend from the earnings of a company. Their share should be
distributed among the members within the limit of an act and with rational behavior of directors.
"Dividend policy must be evaluated in light of the objective of the firm namely, to choose a policy
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that will maximize the value of the firm to its shareholders" Financial Management and Policy.
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As we know in corporation, owners are shareholders but management is done through Board of
directors. It is the Board of Directors to decide whether to pay dividend or retain earnings for
future projects. It is a matter of conflict between shareholders and directors. Shareholders expect a
quick return on their capital. On the other hand, directors have to consider a number of factors in
determining divided policy.
Investors must keep an eye on the company's dividend policy for most companies regular boosts in
the face of irregular earnings can be a warning signal. So can the refusal of Management to lower
dividends when earning fall or capital requirement rise. Companies with high dividend and rising
debt may be borrowing money to pay shareholders. For investors who are seeking stock that will
advance on their performance and earning and earnings per share, lower dividend may mean high
returns. (Adopted from the Quality of earnings - Thornton O. Glove 1987)
The dividend policy of a company reflects how prudent its financial management is. The future
prospects, expansion, diversification mergers are effected by dividing policies and for
a healthy and buoyant capital market, both dividends and retained earnings are important factors.
Most of the company follows some kind of dividend policy. The usual policy of a company is to
retain a position of net earnings and distribute the remaining amount to the shareholders. Many
factors have to be evaluated before forming a long-term dividend policy.
1.4 TYPES OF DIVIDENDS
Classifications of dividends are based on the form in which they are paid. Following given below
are the different types of dividends:
A. 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.
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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 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.
B. Bonus Shares : (or Stock -dividend in USA)
An issue of bonus share 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.
The declaration of the bonus shares will increase the paid-up 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.
Infect, a bonus issue represents a recapitalization of reserves and surplus. It is merely an
accounting transfer from reserves and surplus to paid up capital.
The following are advantages of the bonus shares to shareholders:
i. 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.
ii. Indication of higher future profits: The issue of bonus shares is normally interpreted by
shareholders as an indication of higher profitability.
iii. 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 dividend of the shareholders will increase in the future.
iv. Psychological Value: The declaration of the bonus issue may have a favorable psychological
effect on shareholders. The receipt of bonus shares gives them a chance sell the shares to
make capital gains without impairing their principal investment. They also associate it with
the prosperity of the company.
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C. Special dividend
In special circumstances Company declares Special dividends. Generally company declares special
dividend in case of abnormal profits.
D. Extra- dividend
An extra dividend is an additional non-recurring dividend paid over and above the regular
dividends by the company. Companies with fluctuating earnings payout additional dividends when
their earnings warrant it, rather than fighting to keep a higher quantity of regular dividends.
E. Annual dividend
When annually company declares and pay dividend is defined as annual dividend.
F. Interim dividend
During the year any time company declares a dividend, it is defined as Interim dividend.
G. Regular cash dividends
Regular cash dividends are those the company exacts to maintain every year. They may be paid
quarterly, monthly, semiannually or annually.
H. Scrip dividends
These are promises to make the payment of dividend at a future date, Instead of paying the
dividend now, the firm elects to pay it at some later date.
The ‘scrip’ issued to stockholders is merely a special form of promissory note or notes payable
I. Liquidating dividends
These dividends are those which reduce paid-in capital: It is a pro-rata distribution of cash or
property to stockholders as part of the dissolution of a business.
J. Property dividends
These dividends are payable in assets of the corporation other than cash. For example, a firm may
distribute samples of its own product or shares in another company it owns to its stockholders.
1.5 THE DIVIDEND DECISION
Who Makes Dividend Decision?
The company's Board of Directors makes dividend decisions. They are faced with the decision to
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pay out dividends or to reinvest the cash into new projects.
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The tradeoff between paying dividends and retaining profits within the company The dividend
policy decision is a trade-off between retaining earnings v/s paying out cash dividends. Dividend
policies must always consider two basic objectives:
i. Maximizing owners' wealth
ii. Providing sufficient financing
While determining a firm's dividend policy, management must find a balance between current
income for stockholders (dividends) and future growth of the company (retained earnings).
In applying a rational framework for dividend policy, a firm must consider the following two
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issues:
i. How much cash is available for paying dividends to equity investors, after meeting all needs-
debt payments, capital expenditures and working capital (i.e. Free Cash Flow to Equity -
FCFE)
ii. To what extent are good projects available to the firm (i.e. Return on equity -ROE > Required
Return).
1.6 DIVIDEND PAYMENT PROCEDURES
The firm's board of directors normally meets quarterly to evaluate financial performance and
decide whether, and in what amount, dividends should be paid. If dividend is to be paid the
declaration date, record date etc. have to be established.
Significant dates
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Ex-Dividend date: Shares become ex dividend on the date seller is entitled to keep the dividend.
This is the first date on which the buyer who buys the stock is not entitled to dividend.
1.7 DIVIDEND POLICY THEORIES:
Over the time various theories of dividend policy have emerged; some of the main theories are as
follows:
A. THE RESIDUAL THEORY OF DIVIDEND POLICY:
The residual theory of dividend policy holds that the firm will only pay dividend from residual
earnings, that is dividends should be paid only if funds remain after the optimum level of capital
expenditures is incurred i.e. all suitable investment opportunities have been financed.
With a residual dividend policy, the primary focus of the firm is on investments and hence
dividend policy is a passive decision variable. The value of a firm is a direct function of its
investment decisions thus making dividend policy irrelevant.
B. DIVIDEND IRRELEVANCY THEORY, (Miller & Modigliani, 1961)11
The dividend irrelevancy theory asserts that dividend policy has no effect on either the price of the
firm or its cost of capital.
Dividend Irrelevance Arguments
Dividend policy does not affect share price because the value of the firm is a function of its earning
power and the risk of its assets. If dividends do affect value, it is only due to:
a. Information effect: The informational content of dividends relative to management's earnings
expectations.
b. Clientele effect: A clientele effect exists which allows firms to attract shareholders whose
dividend preferences match the firm's historical dividend payout patterns.
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A study conducted by Aswath Damodaran found that:
a) Older investors were more likely to hold high dividend stocks and
b) Poorer investors tended to hold high dividend stocks hence, firms with older investors pay
higher dividends and firms with wealthier investors pay lower dividends.
The Clientele Effect
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Worth
Individuals
Tax Exempt
Individuals
Firm - B - Dividends
capital investment policy as well as other factors that limit its application to real world situations.
17, 18
C. THE BIRD IN THE HAND THEORY, (John Lintner 1962 and Myron Gordon, 1963) The
essence of this theory is not stockholders are risk averse and prefer current dividends due to their
lower level of risk as compared to future dividends.
Dividend payments reduce investor uncertainty and thereby increase stock value. This theory is
based on the logic that ' what is available at present is preferable to what may be available in the
future'. Investors would prefer to have a sure dividend now rather than a promised dividend
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in the future (even if the promised dividend is larger). Hence dividend policy is relevant and does
affect the share price of a firm.
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H. A SUMMARY VIEW OF DIVIDEND POLICY THEORIES
The dividend policy theories focus on the issue of the relevancy of dividend policy to the value of a
firm.
Dividend Irrelevance
Dividends do not make any difference (M & M theory)
If there are no taxes disadvantages associated with dividends.
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According to the MM hypothesis, market value of a share before dividend is declared is equal to
the present value of dividends paid plus the market value of the share after dividend is declared.
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B. WALTER'S APPROACH
According to Prof. James E. Walter, in the long run, share prices reflect the present value
of future+ dividends. According to him investment policy and dividend policy are inter
related and the choice of a appropriate dividend policy affects the value of an enterprise.
His formula for determination of expected market price of a share is as follows:
P = D + r/k(E-D)
K
Where, P = Market price of equity share
D = Dividend per share
E = Earnings per share
(E-D) = Retained earnings per share
r = Internal rate of return on investment
k = cost of capital
C. GORDON'S APPROACH/ DIVIDEND YIELD BASIS 24
The value of a share, like any other financial asset, is the present value of the future cash flows
associated with ownership. On this view, the value of the share is calculated as the present value of
an infinite stream of dividends.
Myron Gordon's Dividend Growth Model explains how dividend policy of a firm is a basis of
establishing share value. Gordon's model uses the dividend capitalization approach for stock
valuation. The formula used is as follows:
Po = E1 (1-b)
K-br
Where, Po = price per share at the end of year 0
E1 = earnings per share at the end of year 1 (1-b) = fraction of
earnings the firm distributes by way of dividends b = fraction of
earnings the firm ploughs back
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k = rate of return required by shareholders
r = rate of return earned on investments made by the
firm br = growth rate of dividend and earnings
The models, provided by Walter and Gordon lead to the following implications:
If r > k Price per share increases as dividend payout ratio decreases
If r = k Price per share remains unchanged with changes in dividend
Payout ratio
If r < k Price per share increases as dividend payout ratio increases.
This further implies that:
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However, dividend policies may vary between various firms as every firm sets its own policy for
dividend distribution.
Firms may pursue any one of the following dividend policies:
A. GENEROUS OR LIBERAL DIVIDEND POLICY
Firms that follow this policy reward shareholders generously by stepping up dividend over the
time.
B. STABLE DIVIDEND POLICY
Firms may follow the policy of:
Stable dividend payout ratio: According to this policy, the percentage of earnings paid out of
dividends remains constant. The dividends will fluctuate with the earnings of the company.
Stable Naira (inflation adjusted) dividend policy: As per this policy the Naira level of dividends
remains stable.
C. LOW REGULAR DIVIDEND PLUS EXTRA DIVIDEND POLICY
As per this policy, a low, regular dividend is maintained and when times are good an extra
dividend is paid. Extra dividend is the additional dividend optionally paid by the firm if earnings
are higher than normal in a given period. Although the regular portion will be predictable, the total
dividend will be unpredictable.
D. RESIDUAL DIVIDEND POLICY
Under this policy, dividends are paid out of earnings not needed to finance new acceptable capital
projects. The dividends will fluctuate depending on investment opportunities available to the
company.
E. MULTIPLE DIVIDEND INCREASE POLICY
Some firms follow the policy of very frequent and small dividend increases. The objective is to
give shareholders an illusion of movement and growth.
F. ERRATIC DIVIDEND POLICY:
Dividends are paid erratically when the management feels it will not strain the resources of the
firm. Interests of the shareholders are not taken care of while making the dividend decisions.
It has been observed by various researchers that firms generally prefer to follow a stable or a
gradually rising dividend policy.
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G. UNIFORM CASH DIVIDEND PLUS BONUS POLICY
Under this policy, the minimum rate of dividend per share is paid in cash plus bonus shares are
issued out of accumulated reserves. However bonus shares are not given compulsorily on an annual
basis. They may be given over a period of a certain number of years, for example 3-5 years
depending on the accumulated reserves of the company that can be utilized for the purpose of
issuing bonus.
1.10 STABLE DIVIDEND POLICY: A POLICY OF DIVIDEND SMOOTHING
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Lintner (1956) had observed that managers tend to value stable dividend policies and
corporations tend to smooth dividends relative to earnings. That is, dividends are increased
gradually and rarely cut, resulting in a much lower variability of dividends as compared to the
variability in earnings.
Most Companies adapt a basic policy of maintaining its internal reserves to ensure stable income
far into the future, while at the same time seek to distribute a sufficient amount of earnings to
shareholders in accordance with business results. with a decrease in EPS, DPS has decreased and
with increase in earnings the dividend per share has increased .However increase in dividends is
lagging behind increase in earnings in order to ‘smoothen’ or ‘stabilize’ dividend payments over
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the time. Firm may adapt any of the following stable dividend policies:
Stable dividend payout ratio
Stable dividends per share
A regular plus extra dividend policy
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A. STABLE DIVIDEND PAYOUT RATIO:
As per this policy the percentage of dividends paid out of earnings remains constant.
EPS
DPS
Time (Years)
DPS
EPS
Time (Years)
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Earning
Extra
Regular
Dividend
Time (Years)
generally associated with lower capital costs and higher stock prices, other things being equal.
Institutional investors generally prefer to invest in companies having stable dividend records.
Adoption of stable dividends is advantageous for a company interested in raising funds from
external sources as shareholders willingly invest in companies having stable dividends as they
have more confidence in such companies.
The disadvantage is that such a policy might decrease corporate flexibility. Once a company has
adapted a stable dividend policy, any change in such a policy may have adverse effects on the
company image and may result in creating serious doubts in the minds of investors about
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financial standing of the company, which might prove to be very dangerous for the company at a
later stage.
1.11 STEPS TO BE FOLLOWED IN SETTING DIVIDENDS:
The dividend payment procedure involves determination of a firm’s profitable investment
opportunities over a reasonable time horizon; projection of the firm’s operating cash flows
necessary for financing the projects; estimation of the residual funds which can be made available
for distribution; finalizing the target payout rates keeping in view industry trends, financial
soundness of business, future prospects, borrowing capacity etc. among other factors; and finally
setting a feasible payout rate for the current year.
The steps to be followed by a firm in setting dividends are briefly listed as follows:
Determine the investment opportunities with high NPV
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Stage of Growth
Stage I Stage II Stage III Stage IV
Introduction Rapid Growth Maturity Decline
Dividend Policy
No Dividend Low Dividend Payout Policy Growing or Increasing Payout Generous Dividend Payout
Policy Policy
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1.16 REFERENCES
1
CITA ACT, CAP.60 LFN: 1990
2
R.P. Rustagi, Financial Management, Galgotia Publishing Company, 2001.
3
Dr. S.N. Maheshwari, Elements of Financial Management, Sultan Chand and Sons, 1999.
4
Moyer Mc Guigan Kretlow, Contemporary Financial Management, Eight editions, Southwestern College
Publishing, 2001.
5
Ronald C. Lease, Kose John, Avner Kalay. Uri Loewenstein, Oded H. Sarig, Dividend Policy- Its Impact
on Firm Value, Harvard Business School Press, Boston, Massachusetts, 2000 p. 29
6
Janis C. Vanhorn, 1975 F. Management and Policy Prentice Hall of India P. Ltd. N. Delhi, 1975, Page
264.
7
James Walter "Dividend Policy its effluence on the value of enterprise journals of finance-18th May 1963
P. 280
8
James C. Vanhorn, Prantice Hall of India, 1975, P. 263.
9
Lintner, John. "Distribution of Incomes of Corporations among dividends, Retained Earnings and Taxes"
American Economic Review 46, May 1956, p. 97-133
10
Aswath Damodaran, "A Framework For Analyzing Dividend Policy", Corporate Finance: Theory And
Practice, John Wiley and Sons, Inc., 2000.
11
Miller, Merton H., and Modigliani, Franco. "Dividend Policy, Growth and the Valuation of Shares:
Journal of Business 34, No. 4, October 1961, p. 411-433
12
Aswath Damodaran, "The Determinants of Dividend Policy", Corporate Finance: Theory a Practice,
John Wiley and Sons, Inc., 2000.
13
Bhattacharya, S. "Imperfect information, Dividend policy, and 'the bird in the hand fallacy," Bell Journal
of Economics 10, 1979, p. 259-270
14
Miller, Merton, and Kevin Rock, "Dividend Policy Under Asymmetric Information,"'' Journal of Finance,
vol. 40, September 1985, p. 1031-1051
15
John, Kose, and Williams, Joseph. "Dividends, dilutin and Taxes: A signaling Equilibrium." Journal of
Finance 40, no.4, September 1985, p. 1053-1070
16
Williams, Joseph. "Efficient Signaling with Dividends, Investment and stock repurchases." Journal of
Finance 43, no.3, July 1988, p. 737-747
17
Gordon Myron J., "Optimal Investment and Financing Policy:, Journal of Finance, May 1963, p. 264-
272
18
Lintner, John, "Dividends Leverage, Stock Prices, and the Supply of Capital of Corporations", Review of
Economics and Statistics, August 1962, p. 243-269
19
Ravi M Kishore, Dividend Policies and Share Valuation, Taxmann's Financial Management, 2001.
20
Jensen Michael. C., and William Meckling, 'Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure', Journal of Financial Economics, Vol. 3, 1976, p. 305-60
21
Jensen, Michael C., "Agency Cost of Free Cash Flow, Corporate Finance, and Takeovers", American
Economic Review 76666(2), 198, p6. 323-329
22
Dr. S.N. Maheshwari, Elements of Financial Management, Sultan Chand & Sons, New Delhi, 1999.
22
23
James Walter, " Dividend Policy : its influence on the Value of The Firm", Journal Of Finance, May
1963, p. 280-290
24
Prasanna Chandra, "Dividend policy and firm value", Financial Management, Theory and practice, Fifth
edition, Tata McGraw-Hill Publishing Co., New Delhi.
25
Lintner, John, "Distribution of incomes of corporations among dividends retained earnings and taxes",
American Economic Review, 46, May 1956, p. 97-113
26
Prasanna Chandra, Financial Management : Theory and Practice, Tata Mc-Graw-Hill Publishing
Company Ltd., New Delhi, p 496, 497
27
Jim Mc Menamin, Financial Management - An Introduction, Oxford University `Press, Reprinted -
Replica Press Pvt. Ltd., Delhi 110 040, 2000.
A. A. Okwoli, & S. T. Kpelai (2008), Introduction to Managerial Finance, Go-Go Publishers, Jos Plateau
State Nigeria
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