Different types of Dividend

The profits of a company when made available for the distribution among its shareholders are called dividend. The dividend may be as a fixed annual percentage of paid up capital as in the case of preference shares or it may vary according to the prosperity of the company as in the case of ordinary shares.
The decision for distributing or paying a dividend is taken in the meeting of Board of Directors and in confirmed generally by the annual general meeting of the shareholders. The dividend can be declared only out of divisible profits, remained after setting of all the expenses, transferring the reasonable amount of profit to reserve fund and providing for depreciation and taxation for the year. It means if in any year, there is not profits, no dividend shall be distributed that year. The shareholders cannot insist upon the company to declared the dividend. It is solely the discretion of the directors. Aunt hinted that the dividend was an income of the owners of the corporation which they received in the capacity of the owner. Distribution of dividend involves reduction of current assets (cash) but not always. Stock dividend or bonus shares is an exception to it.

Dividend may be of different types. It can be classified according to the mode of its distribution as follows
!--[if !supportLists]-->(1) <!--[endif]-->Regular Dividend. By dividend we mean regular dividend paid annually, proposed by the board of directors and approved by the shareholders in general meeting. It is also known as final dividend because it is usually paid after the finalization of accounts. It sis generally paid in cash as a percentage of paid up capital, say 10 % or 15 % of the capital. Sometimes, it is paid per share. No dividend is paid on calls in advance or calls in arrears. The company is, however, authorised to make provisions in the Articles prohibiting the payment of dividend on shares having calls in arrears. (2) Interim Dividend. If Articles so permit, the directors may decide to pay dividend at any time between the two Annual General Meeting before finalizing the accounts. It is generally declared and paid when company has earned heavy profits or abnormal profits during the year and directors which to pay the profits to shareholders. Such payment of dividend in between the two Annual General meetings before finalizing the accounts is called Interim Dividend. No Interim Dividend can be declared or paid unless depreciation for the full year (not proportionately) has been provided for. It is, thus,, an extra dividend paid during the year requiring no need of approval of the Annual General Meeting. It is paid in cash. (3) Stock-Dividend. Companies, not having good cash position, generally pay dividend in the form of shares by capitalizing the profits of current year and of past years. Such shares are issued instead of paying dividend in cash and called 'Bonus Shares'. Basically there is no change in the equity of shareholders. Certain guidelines have been used by the company Law Board in respect of Bonus Shares.

(4) Scrip Dividend. Scrip dividends are used when earnings justify a dividend, but the cash position of the company is temporarily weak. So, shareholders are issued shares and debentures of other companies. Such payment of dividend is called Scrip Dividend. Shareholders generally do not like such dividend because the shares or debentures, so paid are worthless for the shareholders as directors would use only such investment is which were not . Such dividend was allowed before passing of the Companies (Amendment) Act 1960, but thereafter this unhealthy practice was stopped. (5) Bond Dividends. In rare instances, dividends are paid in the form of debentures or bounds or notes for a long-term period. The effect of such dividend is the same as that of paying dividend in scrips. The shareholders become the secured creditors is the bonds has a lien on assets. (6) Property Dividend. Sometimes, dividend is paid in the form of asset instead of payment of dividend in cash. The distribution of dividend is made whenever the asset is no longer required in the business such as investment or stock of finished goods. But, it is, however, important to note that in India, distribution of dividend is permissible in the form of cash or bonus shares only. Distribution of dividend in any other form is not allowed.

Stability of Dividend
There may be three types of dividend policy (1)>Strict or Conservative dividend Policy which envisages the retention of profits on the cost of dividend pay-out. It helps in strengthening the financial position of the company; (2) Lenient Dividend Policy which views the payment of dividend at the maximum rate possible taking in view the current earing of the company. Under such policy company retains the minimum possible earnings; (3) Stable Dividend Policy suggests a mid-way of the above two views. Under this policy, stable or almost stable rate of dividend is maintained. Company maintains reserves in the years of prosperity and uses them in paying dividend in lean year. If company follows stable dividend policy, the market price of tis shares shall be higher. There are reasons why investors prefer stable dividend policy. Main reasons are:1. Confidence Among Shareholders. A regular and stable dividend payment may serve to resolve uncertainty in the minds of shareholders. The company resorts not to cut the dividend rate even if its profits are lower. It maintains the rate of dividends by appropriating the funds from its reserves. Stable dividend presents a bright future of the company and thus gains the confidence of the shareholders an the goodwill of the company increases in the eyes of the general investors. 2. Income Conscious Investors. The second factor favoring stable dividend policy is that some investors are income conscious and favor a stable rate of dividend. They too,

never favour an unstable rte of dividend. A Stable dividend policy may also satisfy such investors.

3. Stability in Market Price of Shares. Other things beings equal, the market price very with the rate of dividend the company declares on its equity shares. The value of shares of a company having a stable dividend policy fluctuates not widely even if the earnings of the company turn down. Thus, this policy buffer the market price of the stock. 4. Encouragement to Institutional Investors. A stable dividend policy attracts investments from institutional investors such institutional investors generally prepare a list of securities, mainly incorporating the securities of the companies having stable dividend policy in which they invest their surpluses or their long term funds such as pensions or provident funds etc.

In this way, stability and regularity of dividends not only affects the market price of shares but also increases the general credit of the company that pays the company in the long run.

Dividend Relevance: Walters Model

Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. His model is based on the following assumptions: 1. Internal financing: The firm finances all investment through retained earnings; i.e. debt or new equity is not issued. 2. Constant return and cost of capital: the firms rate of return, r , and its cost of capital, k , are constant. 3. 100% payout or retention: All earnings are either distributed as dividends or reinvested internally immediately. 4. Infinite time: the firm has infinite life Valuation Formula: Based on the above assumptions, Walter put forward the following formula: P = DIV + (EPS-DIV) r/k k P = market price per share DIV= dividend per share EPS = earnings per share DIV-EPS= retained earnings per share r = firms average rate of return k= firms cost o capital or capitalisation rate

The above equation is reveals that the market price per share is the sum of two components: The first component k b. The second component (EPS-DIV) r/k is the present value of an infinite stream of k returns from retained earnings. Lets apply the theoretical formula to a practical illustration to improve our understanding. We will take three models, one of a growth firm, the other normal firm and a declining firm. The financial data of all the three firms is given as follows:

Growth firm R K EPS DIV

Normal firm 20% 15% 15% 15% Rs Rs 4 4 Rs Rs 4 4

De fir 10 15 Rs

Rs

Now, we have all the elements of the formula. Lets compute the Share price for the growth firm first. We know that: P = DIV + (EPS-DIV) r/k = 4 +(4-4) 0.20/0.15 k 0.15 By solving the equation, we get the share price equal to Rs 26.67.In the same way, you can get the share price of the other two firms also. i.e. the price of the share for Normal firm is Rs 26.67 and declining firm also it is Rs 26.67. You can see that the price is similar for all the three firms. Now, if you compute the new share price for all the firms if I assume that the dividend is Rs 2 instead of Rs 4 other things remaining the same. Could you get the these share price: Growth firm: Rs 31.11 Normal firm: Rs 26.67 Declining firm: Rs 22.22 Could you note something peculiar here? . When the rate of return is greater than the cost of capital (r > k), the price per share increases as the dividend payout ratio decreases. When the rate of return is equal to the cost of capital (r=k), the price per share does not vary with changes in dividend payout ratio. When the rate of return is lesser than the cost of capital (r< k), the price per share increases as the dividend payout ratio increases. The optimum payout ratio for a growth firm (r > k) is nil. The optimum payout ratio for a normal firm (r = k) is irrelevant

 The optimum payout ratio for a declining firm (r< k) is 100% Despite its popularity does the Walters model suffer from any limitation? As you have seen that this model can be useful to show the effects of dividend policy on all equity firms under different assumptions about the rate of return. However the simplified nature of the model can lead to conclusions, which are not true in general, though true for the model. Lets analyse the model critically on the following points: 1. No External Financing Walters 's model of share valuation mixes dividend policy with investment policy of the firm. The model assumes that retained earnings finance the investment opportunities of the firm only and no external financing-debt or equity-is used for the purpose. When such a situation exists, either the firm's investment or its dividend policy or both will be sub-optimum. Lets take a diagrammatic representation to explain the point. We will take the amount of earnings, investment and financing (in rupees) on the horizontal axis the rates of return and the cost of capital on the vertical axis. It is assumed that the cost of capital, k, remains constant regardless of the amount of new capital raise. 2. Constant rate of return, Walter's model is based on the assumption that r is constant. In fact, r decreases as more and more investment is made. This reflects the assumption that the most profitable investments are made and then the poorer investments are made. Thy firm should stop at a point where r = k. In the figure above, the optimum point of investment occurs at I* where r = k; if the firm's earnings areE2 it pay dividends equal to (E2 - l)*; on the other hand, Walter's model indicates that, if the firms earnings are E2 they should be distributed because r < k at E2. This is clearly an erroneous and will fail to optimise the wealth of the owners. 3. Constant opportunity Cost of Capital, k A firm's cost of capital or discount rate, k, does not remain constant; it changes directly with the risk. Thus, the present value of the firms income moves inversely with the cost of capital. By assuming that the discount rate, k, is constant, Walter's model abstracts from the effect of risk on the value of the firm. I hope that you are clear as we are using examples and diagrammatic presentations very frequently.
So by now you all are clear about the determinants of dividend, main terms in dividend & also about the Walters model of dividend policy. Let us now try some problems to make the concept clearer. Example The following information is available for ABC Ltd. Earnings per share : Rs. 4 Rate of return on investments : 18 percent

Rate of return required by shareholders : 15 percent What will be the price per share as per the walter model if the payout ratio is 40 percent? 50 percent? 60 percent? Solution. According to the Walter model, P = D + (E D) r/k /K Given E = Rs4, r = 0,andk = 0.15, the value of P for the three different payout ratios is as follow: Payout ratio D=EPS * Cost of capital 40 percent 1.6 + (2.40) 0.18/0.15 -------------------------------- = Rs 29.87 0.15 50 percent 2.00 + (2.00) 0.18/0.15 -------------------------------- = Rs29.33 0.15

60 percent 2.40 + (1.60) 0.18/0.15 ---------------------------- = Rs28.80 0.15