UNIT – V

LEVERAGES
The word ‘leverage’, borrowed from physics, is frequently used in financial management.

The object of application of which is made to gain higher financial benefits compared to the fixed charges
payable, as it happens in physics i.e., gaining larger benefits by using lesser amount of force.

“Leverage is the ratio of net returns on shareholders equity and the net rate of return on capitalisation”.

According to J. C. Van Home:

“Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed return.”

Types of Leverage:
(i) Operating leverage

(ii) Financial leverage and

(iii) Combined leverage

1. Operating Leverage:
Operating leverage refers to the use of fixed operating costs such as depreciation, insurance of assets,
repairs and maintenance, property taxes etc. in the operations of a firm. But it does not include interest on debt
capital. Higher the proportion of fixed operating cost as compared to variable cost, higher is the operating
leverage, and vice versa.

2. Financial Leverage:

Financial leverage is primarily concerned with the financial activities which involve raising of funds
from the sources for which a firm has to bear fixed charges such as interest expenses, loan fees etc. These
sources include long-term debt (i.e., debentures, bonds etc.) and preference share capital. 3. Combined
Leverage:

Operating leverage shows the operating risk and is measured by the percentage change in EBIT due to
percentage change in sales. The financial leverage shows the financial risk and is measured by the percentage
change in EPS due to percentage change in EBIT.

SIGNIFICANCE OF LEVERAGE

1. MEASUREMENT OF OPERATING RISK

2. MEASUREMENT OF FINANCIAL RISK
3. MANAGING RISK
4. DESIGNING APPROPRIATE CAPITAL STRUCTURE MIX
5. INCREASE PROFOITABILTY

DIVIDEND POLICY
Definition: A dividend policy can be defined as the dividend distribution guidelines provided by the
board of directors of a company. It sets the parameter for delivering returns to the equity shareholders, on the
capital invested by them in the business.
 Dividend may be defined as divisible profit which is distributed amongst the members of a company in
proportion to their shares in such a manner as is prescribed by the Memorandum and Articles of Association of
a company. It is the share of profits of a company divided amongst its shareholders.

In other words, it is a return that a shareholder gets from the company which is distributed out of its
profits on his shareholdings, i.e., dividend is a distribution to shareholders out of profits or reserves available for
this purpose.

Dividend is the payment by a company to its shareholders out of its distributable profit. In other words,
dividend is paid to the shareholders out of the revenue profits earned by it in the ordinary course of business.
Concepts of Dividend Policy:
(1) Irrelevance Concept of Dividend; and
(2) Relevance Concept of Dividend.
1. Irrelevance Concept of Dividend:
This concept is supported by Franco Modigliani and Morton H. Miller and E. Solomon According to E.
Solomon, the dividend policy of the firm is a residual decision, Residual Theory and dividends are a passive
residual.’ In other words, dividend policy has no effect on the prices of shares of a company and, as such, it has
no significance.
2. Relevance Concept of Dividend:
There are some scholars (viz., James, E. Walter, Myron, J. Gordon, John Linter, and Richardson among
others) who consider dividend decisions to be active variables while determining the firms’ value, i.e., the
dividend decision is assumed to be relevant. According to them, dividend policy of a firm has a direct effect on
the position of a firm in a stock exchange.

Because, higher dividends increase the value of shares whereas low dividend decreases its value in the
market due to the fact that dividends actually presents information relating to the profit earning capacity or
profitability of a firm to the investors.

TYPES OF DIVIDEND POLICIES

There is no definitive way of forming a dividend policy but there are four main types that are used by
most publicly-listed businesses. However, there are additional ways to return cash to shareholders too.

1. Residual dividend policy

2. Stable dividend policy
3. Progressive dividend policy
4. Regular dividend policy
5. Irregular dividend policy (special dividends)
6. Share buybacks
7. Scrip dividends

Residual dividend policy

If a company has a residual dividend policy then it pays whatever cash is left in the business once all
expenditure has been taken into account. This means that shareholders receive the sums left after the company
has taken the likes of capital expenditure, investment and working capital into account.
 This is regarded as the most sustainable and logical dividend policy to have as it means a business only
pays out what it can afford each year. Although, it does mean that dividend payments can be volatile depending
on the performance of the business and its spending requirements: if it suddenly needs to invest more
money then there will be less left for shareholders, or if it underspends then investors will receive more. A
residual dividend policy can be regarded as a form of zero-based budgeting for dividends, with the dividend
being reviewed each year from a zero base and justified each year regardless of previous payouts.

A residual dividend policy provides greater flexibility to companies compared to other policies, as it puts
growth needs and investment before distributions. However, it also means dividends will vary each year
depending on how the business has performed.

Stable dividend policy

If a company has a stable dividend policy then it tries to make a consistent payout each year regardless of
how the business has performed. Instead of basing the dividend on the company’s performance over the short
term, stable dividend policies are more closely linked with long-term prospects and forecasts. Ultimately, the
policy aims to grow dividends at roughly the same rate as long-term earnings. A common way for a stable
policy to be structured is to use a target payout ratio, which outlines what share of its earnings will be returned
to shareholders over the medium to long term.

The benefit of a stable dividend policy is that payouts are reliable and consistent, even if the business
suffers short-term turmoil. A company will try to honour the dividend even if it has had a bad year, dipping into
cash reserves if profits are not enough to cover it, providing something of a safety net for shareholders.
However, it may change the policy or rebase the dividend if it believes its sub-par performance will continue for
longer. This also means that shareholders won’t see a large rise in distributions when the company has a better
than expected year either, with companies more likely to retain the cash.

A stable dividend policy comes with commitment. Investors expect dividends to remain consistent even
if the business enters a downturn, although companies can hoard cash when things when are on the up as they
are not obligated to return it to investors.

Progressive dividend policy

If a company commits to a progressive dividend policy then it is pledging to grow the dividend each
year. Like stable dividends, the payout is linked to long-term earnings forecast for the business. The main
difference is that, if earnings grow, then a progressive policy aims to raise the dividend by a similar amount, but
if earnings fall the company will still raise the payout.

This is a popular policy for investors as it virtually guarantees higher dividends each year regardless of
how the business performs. However, if a company has a progressive payout and is struggling then questions
can be raised about how sustainable the policy is and the justification of spraying shareholders with cash if it
doesn’t have the resources to. A company’s share price can find support if it demonstrates an ability to deliver a
progressive payout over a longer period of time but it does severely limit a company’s flexibility if business
deteriorates.

Regular dividend policy

A regular dividend policy, also known as a constant dividend policy, sees payouts closely linked to the
company’s performance, both rising and falling in line with earnings. This often involves setting
 a payout rate. For example, a payout rate of 20% would mean shareholders will collectively receive 20%
of the company’s earnings each year, whether that be 20% of a £10,000 profit or 20% of a £10 million
profit.

The main characteristic of a regular dividend policy is that payouts move in line with earnings: if the
company reports a 50% rise in profit then dividends should follow suit, but if they fall 50% then so will the
dividend. This means investors reap the reward of a stellar year but also lose out if times have become tough.

This can lead to volatile dividends for investors, but it does mean payouts are more sustainable because
they are directly linked to earnings, and as the business is committing to a fixed rate of earnings it has more
certainty when planning future budgets.

Irregular dividend policies: special dividends

Some companies will pay dividends without adopting a formal dividend policy. Some businesses come
into large amounts of cash that they want to return to shareholders without having to promise it will continue
making payouts in the future. This can happen if a company sells a valuable asset and books a tidy profit.
Similarly, if a business makes a large amount of profit one year but it doesn’t expect that to repeat going
forward then it may pay a dividend without adopting a policy.

There are two primary ways of making a one-off distribution to shareholders. The first is what is known
as a ‘special dividend’. These are one-off payments made to shareholders and often made in addition to
‘ordinary dividends’. This ensures that the one-off special payout doesn’t distort the ordinary dividend policy or
raise expectations for the following year. If a special payout was combined with the ordinary one then there is a
risk that shareholders will expect an even larger payout the following year, even if the driver of
the special payout (such as an asset sale) doesn’t repeat.

Special dividends are a way of making a one-off return to shareholders, which gives businesses great
flexibility. Companies do not usually have a policy for special dividends but some regularly pay them on top of
ordinary dividends.

Share buybacks
The second alternative way of making a distribution to shareholders is through a share buyback. A share
buyback (also known as a share repurchase programme) involves a company repurchasing its own shares from
investors at a pre-determined price, often close to the prevailing share price at the time. This allows a business
to reduce the number of shares in issue – raising the value of each share left in the business – rather than just
pay investors via a dividend.

Companies rarely have share buyback policies and often conduct them alongside ordinary or special
dividends – although, if a business has a large amount of cash it wants to return under a one-off payment then
they will usually only choose to make a special payout or repurchase its own shares, not both. Still, share
buyback programmes can run for years and without a set deadline. For example, a company may pledge to
return $5 billion within three years but it will usually retain flexibility by choosing as and when to buy back the
shares depending on market conditions. The price paid to shareholders under the buyback will often move in
line with the live share price. Companies often opt for share buybacks if it believes it is undervalued as it allows
them to repurchase stock at a cheaper rate and to provide support to shares.
 Share buybacks have numerous advantages over cash dividends. Share buybacks are usually one-offs,
giving businesses flexibility. Repurchasing shares also offsets any dilution that has happened, such as new
shares that have been issued to employees. Buybacks can also be used by a company to raise financial leverage
as it removes equity from the business.

Scrip dividends
It is also worth mentioning scrip dividend programmes, which allow investors to receive new shares in
the company rather than a cash payout. A business operating a scrip dividend will give investors the choice of
receiving the cash dividend or new shares. The value of the cash dividend is usually higher than the scrip
dividend price, but taking new shares is a cost-effective way of increasing your stake in the business and benefit
further from future dividends or special payouts.

Scrip dividends, unless countered with a measure like a buyback, do dilute investors by releasing more
equity. However, it allows businesses to make a return to shareholders without having to spend any cash. Scrip
dividends can also have advantages.

Factors Affecting Dividend Policy

These dividend decisions of an organization are dependent upon the following determinants:
FACTORS AFFECTING DIVIDEND POLICY – LIST OF MAJOR FACTORS WHICH INFLUENCE
DIVIDEND POLICY OF A COMPANY
1. Stability of Earnings:
Stability of earnings is one of the important factors influencing the dividend policy. If earnings are
relatively stable, a firm is in a better position to predict what its future earnings will be and such companies are
more likely to pay out a higher percentage of its earnings in dividends than a concern which has a fluctuating
earnings.
Generally, the concerns which deal in necessities suffer less from fluctuating incomes than those
concern which deal with fancy or luxurious goods.
2. Financing Policy of the Company:
Dividend policy may be affected and influenced by financing policy of the company. If the company
decides to meet its expenses from its earnings, then it will have to pay less dividend to shareholders. On the
other hand, if the company feels, that outside borrowing is cheaper than internal financing, then it may decide to
pay higher rate of dividend to its shareholder. Thus, the internal financing policy of the company influences the
dividend policy of the business firm.
3. Liquidity of Funds:
The liquidity of funds is an important consideration in dividend decisions. According to Guthmann and
Dougall, although it is customary to speak of paying dividends ‘out of profits’, a cash dividend only be paid
from money in the bank. The presence of profit is an accounting phenomenon and a common legal requirement,
with the -cash and working capital position is also necessary in order to judge the ability of the corporation to
pay a cash dividend.
Payment of dividend means, a cash outflow, and hence, the greater the cash position and liquidity of the
firm is determined by the firm’s investment and financing decisions. While the investment decisions determine
the rate of asset expansion and the firm’s needs for funds, the financing decisions determine the manner of
financing.
4. Dividend, Policy of Competitive Concerns:
Another factor which influences, is the dividend policy of other competitive concerns in the market. If
the other competing concerns, are paying higher rate of dividend than this concern, the shareholders may prefer
to invest their money in those concerns rather than in this concern. Hence, every company will have to decide
its dividend policy, by keeping in view the dividend policy of other competitive concerns in the market.
5. Past Dividend Rates:
If the firm is already existing, the dividend rate may be decided on the basis of dividends declared in the
previous years. It is better for the concern to maintain stability in the rate of dividend and hence, generally the
directors will have to keep in mind the rate of dividend declared in the past.
6. Debt Obligations:
A firm which has incurred heavy indebtedness, is not in a position to pay higher dividends to
shareholders. Earning retention is very important for such concerns which are following a programme of
substantial debt reduction. On the other hand, if the company has no debt obligations, it can afford to pay higher
rate of dividend.
7. Ability to Borrow:
Every company requires finance both for expansion programmes as well as for meeting unanticipated
expenses. Hence, the companies have to borrow from the market, well established and large firms have better
access to the capital market than new and small, firms and hence, they can pay higher rate of dividend. The new
companies generally find it difficult to borrow from the market and hence they cannot afford to pay higher rate
of dividend.
8. Growth Needs of the Company:
Another factor which influences the rate of dividend is the growth needs of the company. In case the
company has already expanded considerably, it does not require funds for further expansions. On the other
hand, if the company has expansion programmes, it would need more money for growth and development. Thus
when money for expansion is not, needed, then it is easy for the company to declare higher rate of dividend.
9. Profit Rate:
 Another important consideration for deciding the dividend is the profit rate of the firm. The internal
profitability rate of the firm provides a basis for comparing the productivity of retained earnings to the
alternative return which could be earned elsewhere. Thus, alternative investment opportunities also play an
important role in dividend decisions.
10. Legal Requirements:
While declaring dividend, the board of directors will have to consider the legal restriction. The Indian
Companies Act, 1956, prescribes certain guidelines in respect of declaration and payment of dividends and they
are to be strictly observed by the company for declaring dividends.
11. Policy of Control:
Policy of control is another important factor which influences dividend policy. If the company feels that
no new shareholders should be added, then it will have to pay less dividends. Generally, it is felt, that new
shareholders, can dilute the existing control of the management over the concern. Hence, if maintenance of
existing control is an important consideration, the rate of dividend may be lower so that the company can meet
its financial requirements from its retained earnings without issuing additional shares to the public.
12. Corporate Taxation Policy:
Corporate taxes affect the rate of dividends of the concern. High rates of taxation reduce the residual
profits available for distribution to shareholders. Hence, the rate of dividend is affected. Further, in some
circumstances, government puts dividend tax on distribution of dividends beyond a certain limit. This may also
affect rate of dividend of the concern.
13. Tax Position of Shareholders:
The tax position of shareholders is another influencing factor on dividend decisions. In a company if a
large number of shareholders have already high income from other sources and are bracketed in high income
structure, they will not be interested in high dividends because the large part of the dividend income will go
away by way of income tax. Hence, they prefer capital gains to cash gains, i.e., dividend capital gains here we
mean capital benefit derived by the capitalisation of the reserves or issue of bonus shares.
14. Effect of Trade Cycle:
Trade cycle also influences the dividend policy of the concern. For example, during the period of
inflation, funds generated from depreciation may not be adequate to replace the assets. Consequently there is a
need for retained earnings in order to preserve the earning power of the firm.
15. Attitude of the Interested Group:
A concern may have certain group of interested and powerful shareholders. These people have certain
attitude towards payment of dividend and have a definite say in policy formulation regarding dividend
payments. If they are not interested in higher rate of dividend, shareholders are not likely to get that. On the
other hand, if they are interested in higher rate of dividend, they will manage to make company declare higher
rate of dividend even in the face of many odds.

FACTORS AFFECTING DIVIDEND POLICY – VARIOUS FACTORS THAT HAVE A BEARING ON

THE DIVIDEND POLICY
Factor # 1. Nature of Earnings:
The nature of business has an important bearing on the dividend policy. The industrial units that are
having stability of earnings may formulate (adopt) stable or a more consistent dividend policy than other that
are having variations in earnings, because they can predict easily their earnings.
Factor # 2. Age of Company:
The age of company has more impact on distribution of profits as dividends. A newly started and
growing company may require much of its earnings for financing expansion programms or growth requirements
and it may follow rigid dividend policy, wherein most of the earnings are retained.
Factor # 3. Liquidity Position of Company:
Generally, dividends are paid in the form of cash, hence it entails cash. Although, a firm may have
sufficient profits to declare dividends, it may not have sufficient cash to pay dividends. Thus, availability of
cash and sound financial position of the firm are an important factor in taking dividend decision.
Factor # 4. Equity Shareholders Preference for Current Income:
Legally, the Board of Directors has discretion to decide the distribution of the earnings of a firm. The
shareholders who are legal owners of the firm appoint the (BODs). Hence, directors have to take into
consideration owners’ preferences, while deciding dividend payment. Shareholders’ preference for current
dividends or capital gains depends on their economic status and the effect of tax differential on dividends and
capital gains.
Factor # 5. Requirements of Institutional Investors:
Institutional investors like LICs, GICs and Mutual funds (UTI), have an investment policy, which says
that these type of institutes have to invest only in companies that have a continuous dividend payment record
with stability. They purchase large blocks of shares relatively retail investors to hold or retain for a long period
of time. Hence, they represent a significant force in the financial markets, and their demand for company’s
securities may increase share price and thereby owners’ wealth.
Factor # 6. Legal Rules:
Legal rules are significant as they provide framework within which dividend policy is formulated. In
other words, dividend policy of a firm has to be evolved within the legal framework and rules and regulations.
The legal rules have to do with capital impairment rule, net profits and insolvency rule.
Factor # 7. Contractual Requirements:
Generally, lenders may put conditions in a bond indenture or loan agreement which often includes a
restriction on the payment of dividend. This is done to protect their interests when the firm is experiencing low
liquidity or profitability.
Factor # 8. Financial Needs of the Company:
This is one of the key factors, which influence the dividend policy of a firm. Financial needs means
funds required for foreseeable future investment. The required funds may be determined with the help of long-
term financial forecasts. A firm that has sufficient profitable investment opportunities, it should follow low
dividend payout ratio.
Factor # 9. Access to the Capital Market (External Sources):
Access to the capital market means the firm’s ability to raise funds from the capital market. A company,
which has easy access to the capital market, provides flexibility in deciding dividend policy.
Factor # 10. Control Objective:
Control on the company is also an important factor, which influences dividend policy. When a firm
distributes more earnings as dividends in the form of cash it reduces its cash position. As a result, the firm will
have to issue shares to the public to raise funds required to finance investment opportunities that leads to loss of
control, since, the existing shareholders will have to share control with new owners.
Factor # 11. Inflation:
Inflation is the state of economy in which the prices of products or goods have been increasing. Inflation
is a factor that influences dividend policy indirectly. Indian accounting system is based on historical costs.
Factor # 12. Dividend Policy of Competitors:
Keeping one eye on the competitors’ dividend policy is very important. If the firm wants to retain the
existing shareholders or it wants to maintain share price in the market, and if it is planning to raise funds from
the public for expansion programmes, it has to pay dividends on par with competitors. Hence, it is one of the
factors that influence dividend policy of a firm.
Factor # 13. Past Dividend Rates of the Company:
This is the factor that influences the dividend policy of an existing company (that has already paid
dividends). Owners and prospective investors prefer stability in dividends. Generally, firms’ tries to maintain
stability in dividends that is based on past dividend rates of the company. Hence, directors will have to keep in
mind the past dividend rates while declaring dividends.
Factor # 14. Others:
Apart from the above there are some other factors, which influence dividend policy of a firm, such as
trade cycles, corporate taxation policy, and attitude of investors group and repayment of loan.
Forms Of Dividend Policy
Dividend policy depends upon the nature of the firm, type of shareholder and profitable position. On the basis
of the dividend declaration by the firm, the dividend policy may be classified under the following types:

Regular dividend

Stable dividend policy

Irregular dividend policy

No dividend policy.
Regular Dividend Policy
Dividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable to
the small investors, retired persons and others.
Stable Dividend Policy
Stable dividend policy means payment of certain minimum a mount of dividend regularly. This dividend
policy consists of the following three importa nt forms:
Constant dividend per share
Constant payout ratio
Stable rupee dividend plus extra dividend.
Irregular Dividend Policy
When the companies are facing constraints of earnings and unsuccessful business operation, they may
follow irregular dividend policy. It is one of the temporary arrangements to meet the financial problems. These
types are having adequate profit.
For others no dividend is distributed.
No Dividend Policy
Sometimes the company may follow no dividend policy because of its unfavourable working capital
position of the a mo unt required for future growth of the concerns.

Forms Of Dividends
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are common and
popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type,
cash is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the
existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay
cash dividend, the company promises to pay the shareholder at a future specific date with the help of issue of
bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under the
exceptional circumstance. This type of dividend is not published in India.