Dividend Policy

A dividend policy outlines how a company will distribute its dividends to its
shareholders. This policy details specifics about payouts including how often,
when, and how much is distributed.

There are many types of dividend police including stable, constant, and
residual policies.

A dividend policy is a set of guidelines or rules a company follows when

deciding how much of its profits to distribute to its shareholders as
dividends.

In India, the dividend policy is determined by the company's Board of

Directors, considering the company's financial performance, future
investments, capital requirements, and other factors.

Objectives of a Dividend Policy

1. Provide Shareholder Return: A dividend policy rewards shareholders by

distributing a portion of profits as dividends. This attracts new investors and
provides a return on investment.

2. Maintain Investor Confidence: Consistent dividend payments boost

investor confidence in the company's financial stability, positively affecting
the stock price and market perception.

3. Capital Allocation: A dividend policy decides how much of earnings should

be retained for reinvestment (e.g., for expansion, research) and how much
should be distributed as dividends

4. Shareholder Satisfaction: Consistent dividend payments foster loyalty and

reduce the likelihood of activist shareholders or hostile takeovers

5. Tax Considerations: A dividend policy takes into account tax implications

for shareholders.

6. Access to Capital: Dividends attract income-oriented investors, broadening

the investor base and providing access to a different class of shareholders.

7. Signal Financial Health: Consistent dividend payments signal financial

stability and confidence in future prospects.

8 Flexibility: The dividend policy can adapt to changing economic conditions

and business needs.
9. Competitive Advantage: A well-structured dividend policy can distinguish a
company from others in the same industry and attract long-term investors
Nature of Dividend

Dividend decision is the financing decision of a business. It is the distribution of revenue

profit to the shareholders in proportion to their holdings.

The nature of dividends is discussed below:

i. Cash or Non-cash: Dividends may either be in cash or non-cash. Dividends are generally
paid in cash to the shareholders but sometimes instead of cash payments, shares are issued
to the existing shareholders, free of cash—which is known as issue of bonus shares.

ii. Final or Interim: After finalization of accounts, the directors judge the financial position
and then recommend the amount of dividend at the annual general meeting. Such dividend
is called final dividend whereas any dividend paid between two annual general meetings is
called interim dividend.

ii. Fixed or Variable: In case of profit, preference shareholders are entitled to get dividend at
a fixed rate as per terms of their issue. Equity shareholders are entitled to get dividend out
of the balance left after payment of preference dividend and their rate of dividend may vary
from year to year depending on the volume of profit.

Types of Dividends

1. Cash dividends

These are the most common type of dividends, paid out in cash. A company pays out a
certain portion of its profits as dividends to shareholders. For example, An IT firm, XYZ, has
made Rs 500 crores in profit for the year 2020. They decided to pay their shareholders 20%
of that amount as a dividend, which would be

Rs 100 Crore INR (500 Cr x 0.20).

This would mean each shareholder would receive a certain dividend amount, depending on
how much stock they own. The advantages and disadvantages of cash dividends depend on
the company's financial situation. On the one hand, shareholders can benefit from receiving
a dividend payment in the form of cash; on the other hand, companies have less money to
reinvest in their businesses, which can limit growth potential.Cash dividends provide an
immediate return but also mean less money for companies to reinvest and grow

2. Stock dividends

As the name suggests, stock dividends are paid out as additional shares instead of cash. For
example, XYZ IT firm decided to pay its shareholders 20% of its profits as a stock dividend.
This would mean each shareholder will receive an additional share for every five shares they
own.The advantage of stock dividends is that they can increase a shareholder's potential
returns without them having to invest more money. Additionally, companies won't have to
part with their profits as they do with cash dividends.
On the downside, they also don't provide immediate benefits and tend to carry more risk
than cash dividends. The market value of the new shares could be lower or higher than
when the original investment was made.

3. Property dividends

These various forms of dividend are paid out as assets instead of cash or shares. This could
be anything from real estate to antiques and can even include intangible assets such as
patents or copyrights.

The advantage of property dividends is that they can diversify an investment portfolio and
may provide more tax benefits than other types of dividends. On the downside, there is
always a risk that the value of these types of assets may decline over time, limiting potential
returns.

For example, XYZ IT firm pays its shareholders 10% of its profits as property dividends. This
would mean each shareholder will receive an additional asset worth Rs 50 Lakhs INR (500 Cr
x 0.10).

4. Scrip dividends

Scrip dividends are similar to stock dividends, but instead of receiving additional shares
directly from the company, shareholders receive a scrip or voucher that can be exchanged
for shares on the market.

The advantage of scrip dividends is that they can provide more flexibility to investors as it
allows them to decide when and how much of their dividend money should be used for
reinvestment. On the downside, there is always a risk that the value of these types of assets
may decline over time, limiting potential returns.

For example, XYZ IT firm decides to pay its shareholders 10% of its profits as a scrip
dividend. This would mean each shareholder will receive a scrip worth Rs 50 Lakhs INR (500
Cr x 0.10) that can be exchanged for market shares later.

5. Liquidating dividends

Liquidating dividends are paid out to shareholders when a company is winding down its
operations, and there isn't enough money left to pay out other different types of dividends.

The advantage of liquidating dividends is that they can provide a return for shareholders
even if the business has failed. On the downside, it typically means that all remaining assets
will be sold off to pay the dividend, and the company will cease to exist.

For example, XYZ IT firm decides to pay its shareholders 50% of its remaining assets as a
liquidating dividend. This would mean each shareholder will receive an amount equivalent to
Rs 250 Lakhs INR (500 Cr x 0.50) from the sale of the company's assets

Determinants of Dividend Policy

● Type of Industry

The type of earnings determines dividends because a company with stable earnings has a
more stable dividend policy than a company with unstable earnings. In comparison to
industrial concerns, public utilities, for example, are in a much better position.
● The Extent of Share Distribution

Before establishing a dividend policy, the company consults with all stakeholders. However,
industries with more widely dispersed stakeholders would have a much more difficult time
obtaining such consent.

● Business Cycles

Corporate executives have adequate reserves to deal with the post-inflationary period crisis.
Higher dividend rates are used to promote securities in a down market.

● Profit Trends

When deciding on a dividend policy, the company’s profit history should be thoroughly
examined to determine the company’s average earnings. When depression is on the horizon,
only a conservative dividend policy can be considered prudent.

● Age of Corporation

Making a dividend policy is difficult for a newly established company. In contrast, old
companies with more accruing experience can create a clear-cut payout policy and be liberal
with dividend distribution.

● Additional Capital Needs

The amount of profit required to reinvest in the business significantly impacts dividend
policy. The income could be saved to meet the increased working capital requirements or for
future expansion.

● Taxation Policy

The amount of money paid in taxes impacts the dividend policy, both directly and indirectly.
After taxes, the amount of profit distributed to shareholders decreases.

● Changes in Government Policies

The government may limit the rate of dividends proclaimed by businesses in a specific
industry or in all realms of business activity at times.

● Cash balance

Cash balance is another determinant of dividend policy. If a company’s working capital is

low, it cannot implement a comparatively tiny liberal dividend payment policy. The dividend
must be paid in the form of share capital to members in this case rather than cash.

Walter's Model Of Dividend

Walter's Model focuses on the relationship between dividends and share prices. It suggests
that the choice of dividend policy can affect a company's value. According to this Model,
dividends are reinvested in profitable investments, leading to higher future earnings.

Assumptions in Walter’s Dividend Model

● All the financial domains like return or cost used will be savings. No external earning or

investment will be used.

● The value of rate (r) of return and the value of the cost of capital (k) will never change. It
will remain constant, even if investment value changes.

● The entire return will be distributed among the shareholders through dividends. The
organisation does not keep a single percentage of the return value.

● Every share’s earnings will remain equal to the dividend on every share.

● The organisation’s standard must be standard and perpetual, so the organisation fulfils
the needs of the model.

Limitations of Walter’s Model

● It is assumed that no external earning or investment is used in this model. In this case,
the value of investment policy and dividend policy comes below standard.

● The scope of Walter’s Model is limited to equity-based organisations. In this model, it is

assumed that the rate of return never changes, but its value decreases as investment
increases.

In Walter’s Model, the value of the cost of capital never changes, which is an unrealistic
approach. This assumption ignores the risk on the organisation and the impacts of risk on
the organisation’s value.

Gordon’s Theory on Dividend Policy

Gordon’s theory on dividend policy is one of the theories believing in the ‘relevance of
dividends’ concept. It is also called as ‘Bird-in-the-hand’ theory that states that the current
dividends are important in determining the value of the firm. Gordon’s model is one of the
most popular mathematical models to calculate the

market value of the company using its dividend policy.

Myron Gordon’s model explicitly relates the market value of the company to its dividend
policy. The determinants of the market value of the share are the perpetual stream of future
dividends to be paid, the cost of capital and the expected annual growth rate of the
company.

ASSUMPTIONS OF GORDON’S MODEL Gordon’s model is based on the following assumptions:

NO DEBT The model assumes that the company is an all equity company, with no
proportion of debt in the capital structure.

NO EXTERNAL FINANCING The model assumes that all investment of the company is
financed by retained earnings and no external financing is required.

CONSTANT IRR The model assumes a constant Internal Rate of Return (r), ignoring the
diminishing marginal

efficiency of the investment.

CONSTANT COST OF CAPITAL The model is based on the assumption of a constant cost of
capital (k), implying the business risk of all the investments to be the same.
PERPETUAL EARNINGS Gordon’s model believes in the theory of perpetual earnings for the
company

Gordon’s formula to calculate the market price per share (P) is

P = {EPS * (1-b)} / (k-g)

Where, P = market price per share

EPS = earnings per share

b= retention ratio of the firm

(1-b) = payout ratio of the firm

k = cost of capital of the firm

g = growth rate of the firm