CS EXECUTIVE FSM DIVIDEND POLICY: MEANING, TYPES & FORMS
Dividend Policy is one of the crucial areas in financial management. A dividend is nothing by the distribution of profits by a company to its shareholders. It denotes the shareholders’ wealth and the benefits they arrive out of their investment into the share of the company.Dividend Policy predominantly deals with the decision making of the distribution of profits. When a company earns a profit or surplus, it has an option to pay a proportion of the profit as a dividend to shareholders or to re-invest the same into the business (called retained earnings).
So the ideal study of dividend policy is to, arrive at whether the company can distribute all of its profits, or hold all of its profits as retained earnings, or to distribute the part and retain the remaining. Since this policy of the company determines the amount available for financing the organization’s long-term growth plan and it plays a very vital role.
In this article, we are going to broadly cover the basic concepts of dividend policy, meaning of Dividend Policy, types of dividend policies, determinants of dividend policy, and forms of a dividend. The theory of dividend is a pretty practical topic which needs more examples so maybe it may be discussed separately in an upcoming article. Let’s start with the basic concept.
DIVIDEND POLICY MEANING:
To reiterate, dividend policy is the tool to determine the portion of profits to be paid out to shareholders and what portion will be retained in the business to finance long-term growth. To go with the terminology the ratio to profits to be paid out as a dividend is referred to as payout ratio and the profits retained for growth prospects in the future are referred to as retention ratio.
Payout Ratio = 1 – Retention Ratio
The reason of the importance of dividend policy grew eventually because the dividend constitutes the cash flow that accrues to equity shareholders, on the other hand, the retained earnings are one of the main sources for financing the growth opportunities of the company. Thus, both are desirable but are conflicting goals to each other. A higher dividend leads to less retained earnings and vice versa. This keeps a challenge before the company and has necessitated having a dividend policy in place which will develop a balanced approach of dividend payments having no adverse effects on the growth plans of the company.
The motive of every successful organization is predominantly profit maximization and wealth maximization. Theories would suggest that the company should retain all funds so that it can be employed at a higher rate than the capitalization rate. However, on the other side, shareholders’ preference and their wealth maximization must also be considered. This makes the policy decision challenging.
TYPES OF DIVIDEND POLICIES
There are four types of dividend policies, namely:
Regular Dividend Policy: In a regular dividend policy the shareholders will get dividends at the usual rate. These are commonly preferred by persons who want to get regular incomes. However, this is only possible if the company has regular earning to declare dividends.
Stable Dividend Policy: Here in case of a stable dividend policy dividend payment of a certain sum of money is regularly made to the shareholders, notably even if the company has no profitable earning during that period. There are three types of stable policy, they are:
Constant dividend per share: In this case, a reserve fund is created by the company to accommodate and pay a fixed amount of dividend in the year when the earnings of the company are not enough to pay the dividend. It is suitable only for the company’s having a stable earning.
Constant payout ratio: In this type, the fixed percentage of earning is paid as dividends to shareholders every year.
Stable rupee dividend + extra dividends: This type of dividend is a hybrid one, wherein there is a constant payment of low dividend per share every year and eligibility of extra dividends when the company earns a high profit. This extra dividend is considered as a “bonus” paid as a result of usually a prospective year for the company. Subject to the firm’s liquidity position, this additional dividend shall be paid in the form of cash or bonus shares, as the case may be.
IRREGULAR DIVIDEND: This is a very practical one wherein the company does not pay regular dividends to the shareholders, especially the companies in its early stages of break even. The company may adopt this due to various reasons, viz.,
- due to uncertain earning of the company
- due to lack of liquid resources
- the company is sometimes afraid of giving regular dividend
- due to uncertainty of business
NO DIVIDEND: similarly the company uses this type of dividend policy where no dividend is paid out. This is due to the requirement of funds for the growth of the company or for the working capital requirement which is a constant uptick.
Browse the video lecture on DIVIDEND POLICY – Financial Management & Strategic Management – CS Executive for better understanding.
DETERMINANTS OF DIVIDEND POLICY
As per the regulatory framework, the dividend policy is determined by the Board of Directors under the provisions of Section 123 of the Companies Act, 2013, and respective provisions under the Income Tax Act, 1961. Since this is a very crucial and signification decision number of factors are taken into the following considerations, namely,
- Legal Framework: The first and foremost determinant that influences the dividend policy is the legal framework. Declaration of cash dividend has been regulated with several legal constraints so as a company may not pay adividend which will impair capital. It provides that the dividend must be paid only out of the company’spast/current earnings. This is to ensure that no capital impairment happens and the solvency position of the company is fair. Further, restrictions on dividend payments may also be imposed base on any contract or agreement relating to the loans availed by the company.
- Liquidity and Financial position: The very next requirement is to have funds. A firm can pay dividends only if it has sufficient cash funds to disburse. Therefore liquidity of the funds comes financial constraints to dividend policy. A company can’t declare or pay dividends when its earnings are in accounts receivables or do not have adequate liquidity.
- Economic Constraints: Besides other determinants, there are economic constraints as well. As we have seen earlier, the purpose of the dividend is to maximize the wealth of the shareholder, then it should satisfy the question, does the value of dividend has an impact on the value of the company. If so, the company must formulate an optimum dividend policy which maximizes the market price of the company’s stock.
- Nature of Business of the Company: As the company preferring to have a dividend policy in place it shall ascertain the same based on the nature of the business it carries on. For instance, a company that generates regular earnings may like to have a stable and consistent dividend policy such as industries in the manufacturing of consumer durable items.
- Longer Existence: The history of existence does affect the dividend policy of the company. Having a long-standing experience in the industry, the company would have a better dividend policy than the new companies.
- Type of Organization: The type of organization is another factor. In the case of a private company which is mostly a closely held company, a conservative dividend policy keeping mind the growth of the company. Whereas in the case of a public limited company which shares of the company are widely spread a progressive and promising dividend policy may be required.
- Financial Need: When it comes to the financial needs of the Company, the availability of adequate funds at right time is an important aspect and it is going to have an impact on the dividend policy of the company. Only after considering the working capital requirement and immediate requirements of funds, the decisions on the extent to which the profits are required to be retained or paid out will be decided. Then the prospects of profit and wealth maximization, the company has to have a sustainable existence and solvency.
- Market Impact: As we all know the market is always uncertain, wait awaits in the future are unknown. This is how the business cycle works. In case of a recession or a depressed market condition, a higher dividend declaration is used to market securities for creating a better image of the company. Apparently, during the boom stage, the company may save more in retained earnings, create reserves for future growth and expansion, or for meeting its working capital requirements.
- Financial Arrangement during Corporate Action: At times of corporate action like merger or amalgamation, the companies follow a liberal policy of dividend distribution to make the company’s securities more attractive.
- Change in Government Policies and Statutory Regulations: Not only in dividend policy but changes in Government Policies and Statutory Regulations is also always a contingent item in the business world. Especially policies affecting earnings such as higher rate of taxation will have its impact on dividend decisions. Similarly the other fiscal, industrial, labor, industrial policies do affect different magnitude in terms of an additional cost or otherwise.
FORMS OF DIVIDEND
Distribution of Dividend may be in the form of cash or stock. The common classification of the form of dividend is as follows:
CASH DIVIDEND: Cash dividend, i.e. declaration of dividend in for of cash is the common and popular form adopted by most of the company. Out of the Profits after Tax of the company, the shareholders are offered dividends in the form of cash.
STOCK DIVIDEND: Stock dividend is nothing but the offering of dividends in form of a share of the company free of cost. It is due to the raising of more finance, whereas the cash is retained by the business concern. Instead, the shares are the company issued to the existing shareholders in the name of the bonus issue.
BOND DIVIDEND: Bond dividends can be referred to as an acknowledgment of a debt that the company owes the shareholder his/ her dividend. It is also known as script dividends. In this case, the company does not have sufficient funds to pay a cash dividend, therefore it issues bonds or notes. The bond or notes is a promise made by the company to the shareholders to pay the dividend at a future specified date.
PROPERTY DIVIDEND: This form of dividend is very remote and does not prevail in India. In form of dividend acts as an alternative to cash or stock dividend. Generally, a property dividend can either include shares of a subsidiary company or physical assets of the company, maybe inventory or assets. Therefore the dividend is recorded at the market value of the assets and gets distributed under exceptional circumstances.
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