Dividend Policy: Definition, Classification and Concepts

After reading this article you will learn about Dividend Policy:- 1. Definition of Dividend Policy 2. Classification of Dividend Policy 3. Concepts.

Definition of Dividend Policy:

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 policy is the policy which concerns quantum of profits to be distributed by way of dividend. This policy implies that the companies introduce a pattern of dividend payment through their Board of Directors which, no doubt, has an implication on the future activities although in practice, this procedure is not followed by most of the companies.

They simply consider each dividend decision in an independent manner. This is primarily due to the fact that the financial manager cannot do anything about it since he works at an advisory capacity. The power to recommend dividend policy and declaration of dividends vest completely in the Board of Directors.

However, we are going to discuss the determinants of dividend policy of the firm which is more practical from the standpoint of dividend itself.

Classification of Dividend Policy:

Dividend may be classified according to:

(a) Sources from which they are derived: e.g.:

(i) Retained Earnings; or

(ii) Current Profit;

(b) Medium in which they are distributed; e.g:

(i) Cash Dividend; or

(ii) Share Dividend (i.e… Bonus Shares);

(c) The regularity with which they are paid; e.g.:

(i) Interim Dividend; or

(ii) Annual Dividend.

According to Section 205 (3) of the Companies Act, dividend must be paid in cash except when the company decides to capitalize profits/reserves by issuing fully paid up bonus shares or making partly paid up shares into fully paid up. That is Scrip Dividends cannot be paid and it is 110 longer legal in India.

According to Section 205 of the Companies Act, dividend can be declared or paid only out of profits of the:

(i) Financial year (after providing for depreciation or

(ii) Out of the undistributed profits of the previous financial year (after providing for depreci­ation) or

(iii) Out of both or

(iv) Out of money’s provided by the Central Government or a State Government for the payment of dividend in pursuance of the guarantee given by that Government.

The net effect of share dividend is to increase the number of outstanding shares and to reduce the book value and market values. This is particularly desirable when the price of shares is considered to be ‘high’. Moreover, a share dividend tends to broaden the ownership base as it is presumed that some shareholders will sell some of their shares in order to obtain cash.

It has also a good effect. That is, it allows firm to conserve cash particularly when the firm is in a shortage of liquid funds. This is specially significant to growth companies, since as a general rule they are constantly short of cash, Besides the above, it permits the firm to secure funds for expansion purposes from internal rather than external sources since the former is cheaper and most convenient than external sources.

According to Clause 86, Table A, the Board of Directors may from time to lime pay to the shareholders interim dividend which appears to be justified by the profits of the company. Interim dividend is a dividend which is declared between two annual general meetings, i.e., before the declaration of the final dividend.

For this purpose, interim accounts are prepared. However, final dividends may or may not be inclusive of interim dividend although generally the final proposed dividend is inclusive of interim dividend so paid. But the directors will set aside the amounts which are already paid out of the profits of the company, before recommending final dividend. As such, payment of dividend and retention are almost the same thing.

In short, if more profit is retained, the rate of dividend will be reduced and if the entire profit is paid by way of dividend, the same will impair the growth of the business unit. Therefore, there must be a balance between the two. So, the directors, before declaring the final dividend, should consider some essential factors which are necessary for the purpose.

Dividend policy is the policy which concerns quantum of profit to be distributed by way of dividend. This policy implies that the companies introduce a pattern of dividend payment through their Board of directors which, no doubt, has an implication on the future activities although in practice, this procedure is not followed by most of the companies.

They simply consider each dividend decision in an independent manner. This is primarily due to the fact that the financial manager cannot do anything about it since he works at an advisory capacity. he power to recommend dividend policy and declaration of dividends vest completely in the Board of directors.

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.

According to them, dividends are irrelevant, or are a passive residual, i.e., in their opinion, investors are indifferent between dividends and capital gains. The ultimate desire of the investors is to earn higher return on their investment.

If the firm has adequate investment opportunities which yields a higher rate of return in-comparison with the cost of retained earnings the investors would be content with the firm for retaining the earnings.

In the opposite case, however, i.e., if the retention is less than the cost of retained earnings, investors would prefer to receive earnings i.e., divi­dends. So, it is needless to mention that a dividend decision is nothing but a financing decision.

In short, if the firm has profitable investment opportunities, it will retain the earnings for investment purposes or if not, the said earnings should be distributed by way of dividend among the shareholder/investors.

Residual Theory of Dividend:

According to Solomon, E and Pringle, J. J, dividend, investment and financing decision are interdependent and that trade-offs must be made. Needless to say that either the firm must treat one of the following three basic decisions, viz.,

(i) The amount of new investment;

(ii) The debt-equity ratio; and

(iii) The D/P ratio

As a residual, or, it must take a policy of off-setting dividend payments by issuing fresh equity shares. In other words, the firm cannot use all the above three variables at a time unless it is interested to pay cash dividend and simultaneously issues fresh equity shares.

However, as a matter of policy in the long run, a firm cannot afford to:

(i) Forgo alterative investments;

(ii) Operates at a non-optimal debt-equity ratio/capital structure; and

(iii) Finance dividend payments by selling shares.

As a matter of long run policy, none of the above is sensible and the only policy which avoids one of the above choices is to treat dividends as a long run residual. According to this theory, the equity earnings of the firm are first applied in order to provide equity finance which is required for supporting investments.

The surplus, (i.e, after financing all equity investments needs) if any, would be distributed among the equity shareholders as cash dividends. In other words, dividends are, practically, treated as a residual payment is fulfilling equity investments needs. Similarly, if there is no surplus, naturally, no dividend will be paid. Under the circumstances, dividend policy is nothing but financing decisions.

If we use dividend policy as strictly a financing decision, the payments of cash dividends are a passive residual. We know the amount of dividend pay-out will fluctuates from period to period in keeping with fluctuations is the amount of acceptable investment opportunities available to the firm. It is interesting to note that if these opportunities abound, the percentage of dividend pay-out is likely to be O.

On the other hand, if the firm is unable to find profitable investment opportunities, dividend pay-out will be 100%. For situations between these two extremes, the pay-out will be a fraction between O and l.

The treatment of dividend policy as a passive residual determined strictly by the availability of acceptable investment proposals implies that dividends are irrelevant, the investor is indifferent between dividends and capital gains (retentions). This theory does not always mean that dividends may fluctuate from period to period along with fluctuations in investment opportunities.

Thus, in anticipation of deficit, a firm may declare and pay dividends from its surplus funds created, out of surplus over the past years. If such forecasting is proved to be correct, the firm can fix up its dividend payment at a point by which accumulative distribution over the years corresponding to accumulative residual funds for such period.

In short, the firm would retain earnings for investments in new projects up to the point where the marginal return on new investment equals the marginal cost of capital. So whether the retained earnings would be used for investment purpose or not, the same depends upon the expected return on the available investment opportu­nities.

Needless to say that if it is found that the expected return is more than the marginal cost of capital, the firm will accept the investment proposals within its limit without paying any dividend to the shareholders as the surplus/earnings are used for investment purposes, and vice-versa in the opposite case.

The same can be depicted with the help of the following diagram given below:

Comments:

— Investment Schedule – X:

indicates good investment opportunities in a year where firm can use its retained earnings up to Rs. 50 lakhs, as up to this point, the return exceeds the MCC.

Investment Schedule – Y:

Indicates fewer investment opportunities in a year where a firm can use its retained earnings up to Rs. 40 lakhs, when the return just to exceed MCC.

Investment Schedule – Z:

Indicates for less investment opportunities as it can invest only up to Rs. 30 lakhs and not more.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.