CHAPTER 18

DIVIDEND POLICY
Q.1.
A.1.

Explain the nature of the factors which influence the dividend policy of a firm.
The following factors generally influence the dividend policy of the firm.
1. Shareholders expectations: Shareholders expectation relating to
dividends or capital gains depends on their economic status, effect of
differential tax system, need for regular income, etc.
2. Firms financial needs: Financial needs of the company to finance the
profitable investment opportunities.
3. Legal restrictions: Legal restrictions like dividend to be paid out of
current or past profits do influence dividend policy of a firm.
4. Liquidity: The overall liquidity of a company has an effect on the
dividend decision of a firm. In the absence of sufficient cash, a firm may
be unable to pay dividends even if it has profits.
5. Firms financial condition: The financial condition or capability of a firm
depends on its use of borrowings and interest charges payable. A high
levered firm is expected to retain more profits and distribute lesser
dividends in order to strengthen its equity base.
6. Capital market accessibility: Accessibility by firm to the capital market
becomes an important factor to declare dividends. For example, a fast
growing company which has a tight liquidity position will not face any
difficulty in paying dividends if it has access to the capital markets.
7. Institutional lenders: Lenders of funds like financial institutions and
banks may generally put restrictions on dividend payments to protect
their interests when the firm is experiencing low liquidity or low
profitability, etc.

Q.2.

The primary purpose for which a firm exists is the payment of dividend.
Therefore, irrespective of the firms needs and the desires of shareholders, a firm
should follow a policy of very high dividend payout. Do you agree? Why or why
not?
This statement is not true. The primary purpose of the firm is not payment of
dividend. Rather, it is to maximize shareholders wealth. Paying dividend in
certain situations, may harm, rather than enhance, the shareholders wealth. The
MM view is that dividends are irrelevant. If we consider taxes and assume that
dividend incomes are taxed and capital gains are tax exempt, then paying
dividends will be harmful. On the contrary if capital gains are taxed and dividends
are tax exempt, then it may be in the interest of shareholders if dividends are paid.
A company having profitable growth opportunities will like to retain more and
create shareholder wealth.

A.2.

Q.3.

What are the factors which influence managements decision to pay dividend of a
certain amount?

A.3.

Dividends are paid in cash. A firms dividend policy has the effect of dividing its
net earnings into two parts, i.e., retained earnings and dividends. The retained
earnings provide funds to finance the long term growth. Thus, the distribution of
earnings uses the available cash of the firm. The firm which needs funds to
finance its investment opportunities will have to use external source of financing.
To safeguard the firm from approaching the capital market for external financing,
a firm may not like to distribute cash dividend. Firms with a lot of investment
opportunities do distribute some dividend because paying dividend has
information value. It provides a positive signal to investors about the future
profitability of the firm.

Q.4.

What is a stable dividend policy? Why should it be followed? What can be the
consequences of changing a stable dividend policy?
Stable dividend policy means regularity in paying some dividend annually, even
though the amount of dividend may fluctuate over years, and may not be related
with earnings. Precisely, stability of dividends refers to the amount paid out
regularly. This policy should be followed, because by and large, shareholders
favour this policy and value stable dividends higher than the fluctuating ones. The
stable dividend may have a positive impact as the market price of the share. This
policy resolves uncertainty in the minds of investors about future earnings, and
satisfies the desire of many investors, such as old, retired persons, etc.
If the companies change from the stable dividend policy to an irregular or
fluctuating dividend policy, it gives an unfavourable signal to shareholders about
the stability of the firms operations.

A.4.

Q.5.
A.5.

How is the corporate dividend behaviour determined? Explain Linters model in

this regard.
The firms dividend policy may be expressed either in terms of dividend per share
or dividend rate. According to empirical findings in India, USA and other
countries, corporate managers feel that current dividends depends on current
earnings, the future earnings potential as well as dividends paid in the previous
year. Further, dividends must be paid even when a company needs funds for
undertaking profitable investment projects since dividends have information
value.
Linters model is based on the assumptions that firms generally think in
terms of proportion of earnings to be paid out as dividend. Firms generally have
target payout ratios in view while determining change in dividends. Shareholders
like a steadily growing dividends. Thus, firms change their dividends slowly and
gradually even when there are large increases in earnings. This implies that firms
have standards regarding the speed with which they attempt to move towards the
full adjustment of payout to earnings. Linter has suggested the following formula
for change in dividends of firms in practice:
DIV1 = DIV0 + b (pEPS1 DIV0)
where DIV1 is the expected dividend per share; DIV0 is the dividend per
share of the previous year; p is the target payment ratio; b is the speed of
adjustment; and EPS1 is the expected earnings per share in the current year.

Q.6.
A.6.

Q.7.
A.7.

Q.8.

What are the different payout methods? How do shareholders react to these
methods?
Three distinct forms of dividend payout methods are (1) constant dividend per
share; (2) constant dividend payout ratio; and (3) constant dividend per share plus
extra dividend.
Constant dividend per share: The policy of a company to pay fixed amount per
share or fixed rate on paid-up capital as dividend every year, irrespective of
fluctuations in the earnings. Those investors who have dividends as the only
source of their income may prefer this method. They do not accord much
importance to the changes in the share price.
Constant payout: The ratio of dividend to earnings is known as payout ratio. With
this policy, the amount of dividend will fluctuate in direct proportion to earnings.
Internal financing with retained earnings is automatic when this policy is
followed.
Constant dividend per share plus extra dividend: The policy to pay a minimum
dividend per share with step-up feature is desirable. The small amount of dividend
is fixed to reduce the possibility of ever missing a dividend payment. The extra
dividend may be paid as an interim dividend in periods of prosperity. Certain
shareholders like this policy because of the certain cash flow in the form of the
regular dividend and the option of earning extra dividend occasionally.
What is a bonus issue or stock dividend? What are its advantages and
disadvantages?
Bonus share means distribution of free shares to the existing shareholders. This is
known as stock dividend in the USA. This has the effect of increasing the number
of ordinary shares of the company by capitalisation of retained earnings. In India,
bonus shares cannot be issued in lieu of cash dividend. The earnings per share and
market price per share will fall proportionately to the bonus issue, but the total net
worth of the firm is not affected by the bonus issues.
Advantages
The shareholders are benefited as bonus shares are not taxable as income.
They interpret it as an indication of higher profitability of the firm. If the
company is following the constant dividend policy, then total cash
dividend of the shareholders will increase in future. Some of the
shareholders can sell bonus shares to make capital recovery.
The company is able to retain the earnings and at the same time satisfy the
desires of shareholders to receive dividend. It is the only way for firm to
pay dividend under financial difficulty and contractual restrictions, and
maintain the impression of firm in shareholders mind intact.
Disadvantages
Bonus share have no effect on share value. From the companys point of
view, they are more costly to administer than cash dividend.
Explain a stock split? Why is it used? How does it differ from a bonus shares?

A.8.

A stock (share) split is a method to increase the number of outstanding shares

through a proportional reduction in the par value of the share. A share split affects
only the par value and the number of outstanding shares, the shareholders total
fund remains unaltered. For example, a firms total share capital of Rs 10 crore
being represented by 1 crore shares, each having par value of Rs 10. The firm can
split their shares two-for-one. Then after split off the number of shares will be 2
crore each having par value of Rs 5 and total share capital will remain at Rs 10
crore.
Stock split is done with the main purpose to reduce the market price of the
share and place it in a more popular trading range. This helps in marketability and
liquidity of the companys shares. Generally, when the share is split, the company
seldom reduces dividend per share proportionately, so total dividends of a
shareholder increase after a stock split.
The reduction of the number of outstanding shares by increasing per share
par value is known as reverse split. This may be done, when company wants to
prop up the market price per share.
In case of both bonus share and stock split, the total net worth of firm does
not change, but number of outstanding shares increases substantially.
In case of bonus shares, the balance of the reserves and surpluses account
decreases due to a transfer to the equity capital and share premium accounts. The
par value per share remains unaffected. With a stock split, the balance of the
equity accounts does not change, but the par value per share changes.

Q.9.

Bonus shares represent simply a division of corporate pie into a large number of
pieces. Explain.
The declaration of bonus shares is a method of capitalizing the past earnings of
the shareholders. It is a formal way of recognizing earnings of the shareholders
which they already own. It merely divides the ownership of the company into a
large number of share certificates. The ownership of shareholder does not change
by receipt of bonus share. In short, it represents simply a division of corporate pie
into a large number of pieces.

A.9.

Q.10. What are the effects of bonus issue and share split on the earnings per share and
the market price of the share?
A.10. Bonus shares and stock split reduce the market price of the share reduces and it
becomes more attractive to the shareholders. The reduced market price per share,
place the companys share in a more popular trading range. This helps in
increasing marketability and liquidity of the companys share. The earnings per
share also reduce on account of bonus shares issue and stock split.
Q.11. What is meant by the buyback of shares? What are its effects? Is it really
beneficial to the company and shareholders?
A.11. The buyback of shares is the repurchase of its own shares by a company. In India
companies are authorized to buy back their shares. But they can not do so by
raising debt. They will use their surplus cash for doing so. Also after the buyback,

company can not issue new shares for next 12 months. There are two methods of
the share buyback in India.
1. A company can buy its shares through authorized brokers on the open
market.
2. The company can make a tender offer, which will specify the purchase
price, the total amount, and the period within which shares will be
brought back.
The purpose of the buyback is to provide companies the flexibility of
improving their EPS and share price, to defend themselves from hostile takeovers
and adjust their capital structure.
In practice, share prices may fall if the buyback results into slow growth.
It may not be effective in countering the takeover if it does not have enough
surplus cash.