V.

Issues in dividend policy Normally, a firm would be using its dividend policy to pursue its objective of maximizing its shareholders return so that the value of their investment is maximized. Shareholders return consists of dividends and capital gains. Dividend policy directly influences these two components of return. Even if dividends are not declared but retained in the firm, the shareholders wealth or return would go up. We shall examine various ratios which impact our firms dividend policy: 1. Pay out ratio It is defined as dividend as a percentage of earnings. It is an important concept in the dividend policy. A firm may decide to distribute almost its entire earnings. Another firm may decide to distribute only a portion of its earnings. Initially it may appear, the former firm declares maximum dividends. However in the long run, the latter firm which declares only a portion of its earnings may overtake our former high pay out firm. Let us now look at this with an example. Firms X and Y have equity capital of Rs.100. Let us assume both the firms generate 25% earnings every year. Let us assume that Firm X declares 50% dividend every year and firm Y declares only 25% dividend every year. Firm / Year Equity 25% earnings Firm X 1 2 3 4 5 6 7 8 9 100 112.50 126.56 142.38 160.17 180.19 202.71 228.04 256.54 25 28.12 31.64 35.59 40.04 45.04 50.67 57.01 64.13 12.50 14.06 15.82 17.79 20.02 22.52 25.33 28.50 32.06 12.50 14.06 15.82 17.79 20.02 22.52 25.33 28.50 32.06 Dividend Retained Earnings

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