• Embed Doc
  • Copy Link
  • Readcast
  • Collections
  • CommentGo Back
Download
 
Subject: Financial Management 
Chapter: 10 – Dividend Policy
Chapter No. 10 – Dividend policy
Contents
♦
Need for dividend policy – balance between dividend payment and retention for growth
♦
Different kinds of dividend policies – factors influencing dividend policy
♦
Indian companies declaring dividend – need for cash retention for growth and effectivetax rate influencing dividend policy
♦
Theories on dividend policy
♦
Determining growth rate based on return on equity
♦
Equity valuation based on dividend declared and growth rate
♦
Numerical exercises on equity valuation based on dividend amount and growth rateAt the end of the chapter the student will be able to:
♦
Calculate the cost of equity through dividend capitalization model
♦
Determine the value of equity through the same model and
♦
Find out the growth rate given the return on equity and proportion of retained earnings
Need for dividend policy – balance between dividend payment and retention for growth
As the students know by now “dividend” is paid on share capital. Share capital of both the kinds – equity sharecapital and preference share capital. However there is a difference in respect to dividend between the two. In chapterno. 4 on “Financial resources”, we have seen this difference. In case of preference shares, the dividend rate is fixedwhereas on equity share capital, the dividend rate is not fixed; it can vary depending upon profits for the year andavailable cash for disbursement of dividend. Hence “dividend policy” omits preference share capital and ourdiscussions will only be concerned with equity share capital.Can a company distribute its entire profits as dividend? Even if the board of directors wants it that way it is notpossible as per provisions of The Companies’ Act. It clearly states that depending upon the percentage of dividendon equity share capital, a certain percentage of profits after tax (PAT) needs to be transferred to General Reserves.Hence 100% of PAT cannot be given away as dividend. Further the company needs funds for future growth. Where isit going to get it from in case it distributes more dividends? It can raise fresh equity from its existing shareholders aswell as the market. However there is “public issue” cost to be taken care of.The students will further recall that we need to plough back profits during the year into business to take care of thefollowing:
♦
Repayment of medium and long-term obligations
♦
Contribution towards increase in current assets – a portion of it in the form of Net Working Capital (please seethe chapter on “financial statements analysis” under “funds flow” statement
Punjab Technical University, Online Virtual Campus1
 
Subject: Financial Management 
Chapter: 10 – Dividend Policy
Thus there are three distinct reasons as to why a business enterprise needs to have a balance between dividendspaid out to the shareholders and amount retained in business in the form of reserves.In this context the students may refer to the chapter on “capital structure” in which the difference between theresources of a new unit and an existing unit has been shown. “Retained earnings” are readymade resource availableto a business enterprise.
Measures of Dividend Policy
Dividend Payout measures the percentage of earnings that the company pays in dividends=Dividends/Earnings
Example no. 1
Suppose the PAT of a limited company is Rs. 100 lacs. If it pays Rs. 50 lacs as dividend, the DPO ratio is 50%.The higher the DPO ratio, the less the retention ratio and vice-versaDividend yield measures the return that an investor can make from dividends alone. It is related to the market pricefor the share.= Dividends / Stock Price
Example no. 2
The market price of a stock is Rs. 4000/- and the dividend is Rs. 50/-. Then the dividend yield is 1.25%, which is verypoor in Indian conditions. Thus while dividend rate for the above stock assuming Rs. 100/- as the face value wouldbe 50%, the dividend yield is just Rs. 1.25%
Different kinds of dividend policies – factors influencing dividend policy
The dividend policy of a limited company is closely linked to its profitability and need for cash for financing futuregrowth. Thus there are definite factors influencing dividend policy in a limited company besides the attitude of themanagement – a management may be conservative, declaring less dividends and transferring more to reserves whileaggressive management will declare more dividends and transfer less to “Reserves and surplus”. Let us examinesome of the critical factors influencing “dividend policy” in a limited company.1.Profitability of operations – If the operations are very profitable there is a strong possibility that the dividendrate is high.2.If the company is in the growth phase, the % of dividend will be less – any enterprise in its initial stages ofbusiness immediately after commencement of commercial operations. Just to recap – any business has threedistinct phases in its business, the growth phase, the plateau phase when the % growth is “nil” and the declinephase when the growth is negative. Progressive business houses plan for diversification or any other strategicinitiative that will again take it to the growth phase from the plateau phase, although in a different product line.3.The effective tax rate of the enterprise. Effective tax rate is different from income-tax rate. Income tax rate is 35%+ 10% surcharge thereon, making a total of 38.5%. The amount of actual tax paid by the enterprise depends uponthe degree of tax planning – in short how much the profit subject to tax is different from the profits shown in thebooks. “Depreciation” is one of the most important tools in tax planning. The amount of income-tax depreciationwill usually be higher than the depreciation in the books (as per The Companies’ Act) so much so the book profit(as shown in the audited annual statements of the company) is higher than the income-tax profit. Companiesthat pay high tax rate (whose effective tax rate is high), pay up higher dividend than companies whose effectivetax rate is low.4.The expectations of the investors in the market – this is one of the strongest factors influencing dividend policy.Investors are of different kinds. Better known kinds are – those who prefer dividend, those who prefer capitalgains, i.e., market appreciation, difference between purchase price and present market price and those whoindulge in stocks purely for reasons of speculation. Hence companies do have the compulsion to satisfy the
Punjab Technical University, Online Virtual Campus2
 
Subject: Financial Management 
Chapter: 10 – Dividend Policy
needs of at least a section of investors who look forward to dividends. In fact dividends declared by competitorsin the same industry would be a strong factor in the expectations of investors in a company.5.Cost of borrowing – if the cost of borrowing is less and liquidity in the market is easy, within the debt to equitynorms imposed by the lenders, limited companies will like to retain less and give more dividends. Example –Present debt to equity ratio – 1.5:1. This can go up to 2:1. The cost of borrowing is low. Under the circumstances,a limited company will prefer to retain less earnings and give away more dividends.6.Cost of public issues – if the capital market is active and the cost of raising public issue is not high, limitedcompanies may risk paying high dividends and as and when need arises in future issue further stocks. This hasto be weighed with the need of the management to retain its control of the company. If this need is high, it maynot issue further stocks, which will dilute its control.7.The restrictions imposed by lenders, bond trustees, debenture trustees and others on % of dividends declared bya limited company. As a part of loan agreement, debenture trustee agreement or bond trustee agreement, thereis a clause that restricts the companies from declaring dividends beyond a specified rate without their writtenconsent.8.The compulsion to declare dividend to foreign joint venture partners and institutional investors – when youhave strategic partners in business including foreign investors, you may be required to declare minimum % ofdividend. This is true of institutional investors in India too, who have contributed to the company’s equity. Thisis more relevant in the case of management of limited companies who left to themselves, will not declare anydividends.9.Effects of dividend policy on the market value of the firm – in case in the perception of the management, themarket value is largely dependent upon the rate of dividend, the management will try to increase the rate ofdividend.
Note: It will be apparent to the students that the dividend policy decisions based on above factors canat best be exercises in informed judgement but not decisions that can be quantified precisely. In spiteof this, the above factors do contribute to make rational dividend decisions by Finance Managers.
From the factors influencing dividend policy flow the different kinds of dividend policies as under:1.Stable dividend policy irrespective of profitability – increasing or decreasing. This means that over the years thecompany declares the same % of dividend on the equity share capital. The rates
1
 will neither be too high nor toolow – they will be moderate.2.Stable Dividend payout ratios – Dividend payout ratio is the ratio of dividend payable by a limited company toits Profit After Tax. This could be more or less the same over a period, irrespective of whether the profits aregoing up or coming down. The assumption here is that there are no drastic changes in the profitability of theorganisation, especially when it is on the decrease. It can be visualised by the students that any drastic reductionin profits will result in changes in the DPO.3.Dividend being stepped up periodically – this is possible in the growth phase of the company. The company cancome up with the financial forecast say for the next 10 years and decide to increase the rate of dividend every 5years or three years or so. This may not be true of companies that have been in existence for a long period oftime.Most observers believe that dividend stability if a desirable attribute as seen by investors in the secondary marketbefore they decide to invest in a stock. If this were to be true, it means that investors prefer more predictabledividends to stocks that pay the same average amount of dividends but in an erratic fashion. This means that the costof equity
2
will be minimised and stock price maximised if a firm stabilises its dividends as much as possible.
Indian companies declaring dividend – need for cash retention for growth and effective tax rateinfluencing dividend policy
1
The rate of dividend is always expressed as a percentage of the face value.
2
Cost of equity, k
e =
(D
1
 /P
0
 ) + g. Refer to chapter on “capital structure and cost of capital”. If “g” in dividend rate is minimal, the cost of equityautomatically comes down and this pushes up P
0.
This means that the market value increases with stable dividend policy.
Punjab Technical University, Online Virtual Campus3
of 00

Leave a Comment

You must be to leave a comment.
Submit
Characters: ...
You must be to leave a comment.
Submit
Characters: ...