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LECTURENOTESONFINANCIALMANAGEMENT

DIVIDENDPOLICY

BALKRISHNAPARAB

BalkrishnaParabisafellowoftheInstituteofCompanySecretariesofIndia(ICSI)andan
associateoftheInstituteofCostandWorksAccountantsofIndia.Heisamemberofthe
corefacultyattheJamnalalBajajInstituteofManagementStudies,UniversityofMumbai,
164,H.T.ParikhMarg,BackbayReclamation,Mumbai400020.Contactdetails:
Telephone(O)22024133,22025153,22024118(C)9833528351.email:
<balkrishnaparab@jbims.edu>.

CONTENTS
Introduction.....................................................................................................................................................3
ArgumentsforDividends.................................................................................................................................3
ArgumentsagainstDividends..........................................................................................................................4
DividendPayingApproaches...........................................................................................................................4
FactorsInfluencingDividendPolicy.................................................................................................................4

balkrishnaparab@jbims.edu

DIVIDENDPOLICY

BalkrishnaParab FCS , AICWA


balkrishnaparab@jbims.edu

INTRODUCTION
Successfulcompaniesearnprofits.Thatincomecanthenbereinvestedinoperatingassets,used
toacquiresecurities,usedtoretiredebt,ordistributedtoshareholdersasdividends.Dividends
areonewayinwhichcompaniessharethewealthgeneratedbyrunningthebusiness.Theyare
cashpayment,oftendrawnfromearnings,paidtotheinvestorsinacompanytheshareholders.
Thecompaniesthatpaythemareusuallymorestableandestablished,notfastgrowers.Those
stillintherapidgrowthphaseoftheirlifecycletendtoretainalltheearningsandreinvestthem
intothebusiness.
Ifthedecisionismadetodistributeincometoshareholders,threekeyissuesarise:

Howmuchshouldbedistributed?
Should the distribution be as cash dividends, or should the cash be passed on to
shareholdersbybuyingbacksomeofthestocktheyhold?
How stable should the distribution be; that is, should the funds paid out from year to
year be stable and dependable, which stockholders would probably prefer, or be
allowed to vary with the firms cash flows and investment requirements, which would
probablybebetterfromthefirmsstandpoint?

ARGUMENTSFORDIVIDENDS
Someanalystsbelievethatahighdividendpayoutisimportantforinvestorsbecausedividends
provide certainty about the companys financial wellbeing; dividends are also attractive for
investors looking to secure current income. In addition, there are many examples of how the
decreaseandincreaseofadividenddistributioncanaffectthepriceofashare.Companiesthat
havealongstandinghistoryofstabledividendpayoutswouldbenegativelyaffectedbylowering
or omitting dividend distributions; these companies would be positively affected by increasing

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dividendpayoutsormakingadditionalpayoutsofthesamedividends.Furthermore,companies
withoutadividendhistoryaregenerallyviewedfavourablywhentheydeclarenewdividends.

ARGUMENTSAGAINSTDIVIDENDS
Some financial analysts feel that the consideration of a dividend policy is irrelevant because
investorshavetheabilitytocreatehomemade dividends.Theseanalystsclaimthatthisincome
isachievedbyindividualsadjustingtheirpersonalportfoliostoreflecttheirownpreferences.For
example,investorslookingforasteadystreamofincome aremorelikelytoinvestinbonds(in
whichinterestpaymentsdontchange),ratherthanadividendpayingstock(inwhichvaluecan
fluctuate). Because their interest payments wont change, those who own bonds dont care
aboutaparticularcompanysdividendpolicy.

DIVIDENDPAYINGAPPROACHES
Now,shouldthecompanydecidetofolloweitherthehighorlowdividendmethod,itwoulduse
oneofthreemainapproaches:residual,stability,orahybridcompromisebetweenthetwo.

RESIDUALDIVIDENDPOLICY
Companies using the residual dividend policy choose to rely on internally generated equity to
financeanynewprojects.Asaresult,dividendpaymentscancomeoutoftheresidualorleftover
equity only after all project capital requirements are met. These companies usually attempt to
maintain balance in their debt/equity ratios before making any dividend distributions, which
demonstrates that they decide on dividends only if there is enough money left over after all
operatingandexpansionexpensesaremet.

STABILEDIVIDENDPOLICY
The fluctuation of dividends created by the residual policy significantly contrasts with the
certainty of the dividend stability policy. The aim of a stable dividend policy is to reduce
uncertaintyforinvestorsandtoprovidethemwithincome.

HYBRIDDIVIDENDPOLICY
Thefinalapproachisacombinationbetweentheresidualandstabledividendpolicy.Intodays
markets,thisapproachiscommonlyusedbycompaniesthatpaydividends.Asthesecompanies
will generally experience business cycle fluctuations, they will generally have one set dividend,
whichissetasarelativelysmallportionofyearlyincomeandcanbeeasilymaintained.Ontopof
this set dividend, these companies will offer another extra dividend paid only when income
exceedsgenerallevels.

FACTORSINFLUENCINGDIVIDENDPOLICY
Several factors affect the dividend decision. These factors may be grouped into four broad
categories:
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Constraintsondividendpayments
Investmentopportunities
Availabilityandcostofalternativesourcesofcapital

Eachofthesecategorieshasseveralsubparts,whichwediscussinthefollowingparagraphs.

CONSTRAINTS
BONDINDENTURES
Debtcontractsoftenlimitdividendpaymentstoearningsgeneratedaftertheloanwas
granted. Also, debt contracts often stipulate that no dividends can be paid unless the
current ratio, timesinterest earned ratio, and other safety ratios exceed stated
minimums.
PREFERENCESHARERESTRICTIONS
Typically,dividendscannotbepaidtoequityshareholdersifthecompanyhasomitted
itspreferreddividend.Thearrearsofpreferencesharedividendmustbesatisfiedbefore
commondividendscanberesumed.
IMPAIRMENTOFCAPITALRULE
Dividendpaymentscannotexceedthebalancesheetitemretainedearnings.Thislegal
restriction, known as the impairment of capital rule, is designed to protect creditors.
Without the rule, a company that is in trouble might distribute most of its assets to
stockholdersandleaveitsdebtholdersoutinthecold.
AVAILABILITYOFCASH
Cash dividends can be paid only with cash. Thus, a shortage of cash in the bank can
restrictdividendpayments.However,theabilitytoborrowcanoffsetthisfactor.

INVESTMENTOPPORTUNITIES
AVAILABILITYOFPROFITABLEINVESTMENTOPPORTUNITIES
If a company typically has a large number of profitable investment opportunities, this
will tend to produce a low target payout ratio, and vice versa if the firms profitable
investmentopportunitiesarefewinnumber.
POSSIBILITYOFACCELERATINGORDELAYINGPROJECTS
The ability to accelerate or postpone projects will permit a company to adhere more
closelytoastabledividendpolicy.

ALTERNATIVESOURCESOFCAPITAL
COSTOFISSUINGNEWSHARES
If a company needs to finance a given level of investment, it can obtain equity by
retaining earnings or by issuing new common stock. If flotation costs are high, it is
betterto set alow payoutratioand to financethrough retention rather than through

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issue of new common stock. On the other hand, a high dividend payout ratio is more
feasibleforafirmwhoseflotationcostsarelow.
CONTROL
Ifmanagementisconcernedaboutmaintainingcontrol,itmaybereluctanttosellnew
shares; hence the company may retain more earnings than it otherwise would.
However, if stockholders want higher dividends and a proxy fight looms, then the
dividendwillbeincreased.

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