Dividend Decision

Concept of Dividend
The term dividend refers to that portion of (profit after) which is distributed among the
shareholders of the firm and profit which is not distributed is known as retained earnings.
The dividend is the one of the four basic functional decisions.

In dividend decision, a financial manager is concerned to decide one or more of the

following:
a) Should the profits ploughed back?
b) Whether any dividend be paid? If yes, how much dividends be paid?
c) When these dividends be paid? Interim or final?
d) In what form the dividends be paid? Cash Dividend or Bonus Shares?

(1) Dividend Payout (D/P) Ratio

The D/P ratio indicates the percentage share of the net earnings distributed to the shareholders
as dividends.
A low D/P ratio may cause a decline in share prices, while a high ratio may lead to a rise in the
market price of the shares.

If EPS is Rs. 10 per share &

DPS is Rs. 6 per share
Dividend Payout Ratio = Rs. 6/ Rs. 10 *100 = 60%
Retention Ratio = 100% - 60% = 40%

(2) Stability of Dividends

Stable dividend policy refers to the consistency or regularity in the stream of dividends, that
is, a certain minimum amount of dividend is paid out regularly.
Forms of Stable Dividend
The regularity in payment of dividend may take following three forms:
1. Constant dividend per share policy is a policy of paying a certain fixed amount per share as
dividend.
2. Constant/target payout ratio is a policy to pay a constant percentage of net earnings as
dividend to shareholders in each dividend period.
3. Stable rupee plus extra dividend is a policy based on paying a fixed dividend to
shareholders supplemented by an additional dividend when earnings warrant it.
The investors prefer a stable dividend policy for a number of reasons, such as,
1. Desire for current income their,
2. Informational contents,
3. Institutional requirement, and so on.
Dangers of Stable Dividend Policy
• Once a stable dividend policy is followed by a company, it is not easier to change it
due to following reasons:
– Adversely affects investors perception
– Adversely affects the market price of shares
– Adversely affects the liquidity position

(3) Legal, Contractual, and Internal Constraints and Restrictions

Legal Requirements
Legal stipulations do not require a dividend declaration but they specify the conditions under
which dividends must be paid. Such conditions pertain to
a) Capital impairment
b) Net profits
c) Insolvency

Contractual Requirements
Important restrictions on the payment of dividend may be accepted by a company when
obtaining external capital either by a loan agreement, a debenture indenture, a preference share
agreement, or a lease contract. Such restrictions may cause the firm to restrict the payment of
cash dividends until a certain level of earnings has been achieved or limit the amount of
dividends paid to a certain amount or percentage of earnings.
The financial manager must ensure that the amount of dividend is within the covenants already
committed to lenders.

Internal Constraints
Growth Prospects
Financial Requirements
Availability of Funds
Earnings Stability

Owner’s Considerations
Taxes: The dividend policy of a firm may be dictated by the income tax status of its
shareholders.
Opportunities: The firm should not retain funds if the rate of return earned by it would be less
than one which could have been earned by the investors themselves from external
investments of funds.
Dilution of Ownership: The financial manager should recognise that a high D/P ratio may
result in the dilution of both control and earnings for the existing equity holders

Other Considerations
• Capital Market Considerations: In case the firm has easy access to the capital
market, either because it is financially strong or large in size, it can follow a liberal
dividend policy. However, if the firm has only limited access to capital markets, it is
likely to adopt low dividend payout ratios. Such firms are likely to rely more heavily
on retained earnings as a source of financing their investments.

• Inflation: Finally, inflation is another factor which affects the firm’s dividend
decision. With rising prices, funds generated from depreciation may be inadequate to
replace obsolete equipments. These firms have to rely upon retained earnings as a
source of funds to make up the shortfall. This aspect becomes all the more important
if the assets are to be replaced in the near future. Consequently, their dividend payout
tends to be low during periods of inflation.

(4) Forms of Dividend

The dividend may be paid in different forms:
(a) Cash Dividend:
Cash Dividend is the most common form of dividend. It affects both sides of balance sheet
i.e. assets as well as liabilities.
It reduces:
Cash
Reserves
Net Worth

(b) Bonus Shares (Stock Dividends)

An issue of bonus shares is distribution of shares free of cost to the existing shareholders. The
bonus shares are issued proportionately to the existing shareholders.
For example, if a shareholder owns 100 shares at the time when bonus announcement of 1:10
was made, the shareholder will receive 10 additional shares.
Impact: It has no economic effect, since:
Increases paid up capital
Reduces reserves and surplus
The total net worth remains unaffected.

(c) Share Split

A share split is a method to increase the number of outstanding shares through proportional
reduction in the par value of the share.
Impact:
Par value of share reduces
Number of outstanding shares increases
Net worth remains unaffected

(d) Buy Back of Shares

The buy back of shares is the repurchase of its own shares by a company. It is an alternative
method to pay cash dividends.
Impact:
The number of equity shares outstanding are reduced
No change in corporate earnings
Share repurchase would result in higher (i) EPS and (ii) market price of a share.

(5) Theories of Dividend

Refer pn 65 to 70 of E-book

Assignment
Q 1: Which form of dividend affects the net worth?
Q 2: Describe different forms of dividend and their distinguishing features.