DIVIDEND POLICY

Dividend policy involves the decision to pay out earnings or to retain them in the firm. A
dividend is a distribution of earnings to shareholders, generally paid in the form of cash or
stock. The portion of after tax earnings not paid out as dividends is called retained earnings.

A dividend pay-out ratio is the percentage of earnings paid to shareholders in cash.

The goal of dividend policy is to maximize its contribution toward increasing shareholders’
wealth. An optimal dividend policy strikes that balance between current dividends and future
growth which maximizes the price of firm’s stock and hence, shareholders’ wealth. Selecting
the optimal dividend pay-out rate that achieves that balance is difficult for most companies
because numerous factors influence dividend policy.

Factors Influencing Dividend Policy Numerous factors influence a firm’s choice of

dividend policy. Corporations may face restrictions or limitations on the payment of
dividends.

1. Capital impairment rule: Dividend payments cannot exceed the balance sheet item
“retained earnings”. This legal restriction, known as the impairment of capital rule, is
designed to protect creditors. Without this rule, a company that is in trouble might
distribute most of its assets to stockholders and leave its debt holders out in the cold.

2. Desire for control: Managers of small sized companies may hesitate to pay any
dividends or large dividends for the fear of dilution of cash position of the firm. The
concern is that, if this happened then the owners may look to outside investors for
financing who may want to have a large say in running the company.

3. Preferred stock restrictions: Typically, common dividends cannot be paid if the

company has omitted its preferred dividend. The arrear of preferred dividend must be
paid before common dividends can be resumed.

4. Bond indenture: Debt contracts often stipulate that no dividends can be paid unless
current ratio, Times interest earned ratio, and other safety ratios exceed stated
minimums.

5. Internal constraints: Management is constrained in paying dividends by the availability

of cash. The less liquid a firm is the less able it is to pay dividends.

6. Tax position of shareholders (clientele effect): Individual investors in a high tax

bracket may not desire to receive dividends as it would increase their tax liability. On the
other hand, investors in the lower tax bracket would prefer a constant stream of dividends.

7. Access to capital market: Dividend policy may be affected by the availability of

external financing. New and/or small firms often have limited access to capital markets and
must rely heavily on internal funds to finance profitable projects. Consequently, they restrict
their cash dividend payments. Medium to large firms with good performance records have
relatively easy access to capital markets and thus may adopt more liberal dividend pay-out
policies.

Types of Dividend Policies: There are many distinctive dividend policies, but most policies
fall into one of two categories.

1. Stable Dividend Policy: A stable dividend policy is characterized by the tendency

to keep a stable dollar amount of dividends per share from period to period. Most
firms follow a relatively stable dividend policy for three reasons:
 Many business executive believe that stable dividend policies lead to higher stock
prices. The empirical evidence on the relationship between dividend policy and stock
prices is inconclusive.
 Investors may view constant or steadily increasing dividends as more certain than a
fluctuating cash dividend payment.
 There is less chance to signal erroneous informational content with a stable dividend
policy. Thus, firms tend to avoid reducing the annual dividend because of the
information content that a dividend cut may convey. Example: AP Ltd earned
$40,00,000 last year and paid $1.40 per share in dividends on 10,00,000 outstanding
shares. Because of a temporary slump in the market, the firm expects to earn $36,
00,000 this year. If the company maintains a stable dividend policy, it will maintain a
$1.40 dividend per share, despite the expected decline in earnings.
2. Constant dividend pay-out ratio policy: A constant pay-out ratio policy is one in
which a firm pays out a constant percentage of earnings as dividends. Example: refer
to the data in the previous example. If AP Ltd. maintains a constant dividend pay-out
ratio each year, this year’s dividend per share would be computed as follows: Last
year dividend = $1.4 x 10,00,000 shares = $ 14,00,000 Dividend pay-out ratio =
$14,00,000/ $40,00,000 = 35 % Dividend of the year = 0.35 x $36,00,000 =
$12,60,000 Dividend per share = $ 12,60,000/ 10,00,000= $1.26
3. Residual dividend policy: A policy under which a firm pays dividends only after
meeting its investment needs while maintaining a desired debt equity ratio. With a
residual dividend policy, the firm’s objective is to meet its investment needs and
maintain its desired debt-equity ratio before paying dividends. If a firm wishes to
avoid new equity sales, then it will have to rely on internally generated equity to
finance new projects. Dividends can only be paid out of what is left over. This left
over is called the residual, and such dividend policy is called a residual dividend
approach.

Stock dividends and stock splits:

Stock dividends: A dividend paid in form of additional shares of stock rather than in
cash. Examples: 5% of stock dividend, the holders of 100 shares would receive an
additional 5 shares without cost.
Stock dividend is a distribution of additional shares of stock to existing shareholders
on a pro-rata basis. It is technically a form of dividend payment where no cash is
distributed but the net worth remains unchanged. The stock dividend is usually
expressed as a percentage of the shares held by a shareholder and is normally in the 2
to 10 per cent range. A firm may use stock dividends to conserve cash, supplement
cash dividends and broaden its ownership base. One disadvantage associated with
stock dividends is that they are more costly to administer than cash dividends. With a
stock dividend the shareholder receives neither ownership nor wealth. However, from
the shareholder’s perspective, the advantage is that additional stock is not taxed until
sold whereas a cash dividend is declarable as income in the year it is received.
The accounting treatment of a stock dividend involves transferring an amount equal to
the current market value of the stock dividend from retained earnings to other
stockholders’ equity accounts. This deduction in retained earnings is added to the
common stock account at par value and the remainder is added to the account capital
in excess of par. The par value of the common stock remains unchanged. Thus, the
effect of a stock dividend is to capitalize a portion of the firm’s retained earnings.
Reasons for declaring stock dividend:
1. It increases the number of shares a person holds and therefore increases the
possibility of receiving higher total cash dividends in the future.
2. It reduces the per share price of stock and this could attract others to buy their
shares.
3. It could also be due to the firm’s inability to pay cash dividends at the current time.

Stock splits: An action taken by a firm to increase the number of shares outstanding
such as doubling the number of shares outstanding by giving each stockholder two
new shares for each formerly held.

Taka Share Two for one No of share

80 100 80/2=Tk.40 100×2=200

A stock split is a method of increasing the number of shares of common stock

outstanding without any change in the shareholders’ equity or the aggregate market
value at the time of the split.
The accounting treatment of a stock split involves increasing both the number of
shares authorized and outstanding and dividing the par value of the common stock by
the size of the split. When a stock split requires an increase in authorized shares
and/or change in par value of the stock, the shareholders must approve an amendment
of the corporate charter.