L 16 Dividend Policy

Developed by Dr IKRAM UL HAQ
CHOUDHARY CPA, PhD 1

 Dividend refers to that part of net profits of a company which
is distributed among the shareholders as a return on their
investment in the company. Dividend policy means the broad
approach according to which every year it is determined how
much of the net profits are to be distributed as dividend and
how much are to be retained in the business.

 Dividend Policies involve the decisions, whether-
◦ To retain earnings for capital investment and other purposes;
or
◦ To distribute earnings in the form of dividend among
shareholders; or
◦ To retain some earning and to distribute remaining earnings
to shareholders.

Net earnings of dividend policies
Retained Earnings Dividend

 To consider the net earnings of the firm as a source of long
term funds
 To pay dividend distribution tax on the distributed dividend
 To reduce internal funds available to finance profitable
investment opportunities which constraints growth or
requires the firms to find other costly sources of financing
 To view dividend decision merely as a residual decision

 The payment of dividends may significantly affect the market
price of a share
 In order to maximize wealth under uncertainty, the firm must
pay enough dividends to satisfy the investors
 Their wealth will be maximized if firm’s retain earnings rather
than distributing them

 The typical dividend policy of most firm is to retain between
1/3 to half of the net earnings and distribute the remaining
amount to share holders.
 Companies in Pakistan specify dividends in term of a dividend
rate which is percentage of the paid up capital per share.

 What are the firm’s financial needs given its growth plan and
investment opportunities
 Who are the shareholders of the firm? What are the
preferences regarding dividend payment
 What are the firms’ risk-business and financial
 Should the firm pay stable dividend policy
 How should the firm pay dividends-cash dividends or bonus
share or share buyback

 Stability of Earnings: The nature of business has an important
bearing on the dividend policy. Industrial units having stability of
earnings may formulate a more consistent dividend policy than those
having an uneven flow of incomes because they can predict easily their
savings and earnings. Usually, enterprises dealing in necessities suffer
less from oscillating earnings than those dealing in luxuries or fancy
goods.
 Extent of share Distribution. Nature of ownership also
affects the dividend decisions. A closely held company is likely to
get the assent of the shareholders for the suspension of dividend or
for following a conservative dividend policy. On the other hand, a
company having a good number of shareholders widely distributed
and forming low or medium income group, would face a great
difficulty in securing such assent because they will emphasize to
distribute higher dividend.

 Needs for Additional Capital. Companies retain a part of their
profits for strengthening their financial position. The income may be
conserved for meeting the increased requirements of working capital or of
future expansion. Small companies usually find difficulties in raising
finance for their needs of increased working capital for expansion
programmers. They having no other alternative, use their ploughed back
profits. Thus, such Companies distribute dividend at low rates and retain a
big part of profits.
 Trade Cycles. Business cycles also exercise influence upon dividend
Policy. Dividend policy is adjusted according to the business oscillations.
During the boom, prudent management creates food reserves for
contingencies which follow the inflationary period. Higher rates of dividend
can be used as a tool for marketing the securities in an otherwise depressed
market. The financial solvency can be proved and maintained by the
companies in dull years if the adequate reserves have been built up.

 . Government Policies. The earnings capacity of the enterprise
is widely affected by the change in fiscal, industrial, labour, control
and other government policies. Sometimes government restricts the
distribution of dividend beyond a certain percentage in a particular
industry or in all spheres of business activity as was done in
emergency. The dividend policy has to be modified or formulated
accordingly in those enterprises.
Taxation Policy. High taxation reduces the earnings of he
companies and consequently the rate of dividend is lowered down.
Sometimes government levies dividend-tax of distribution of
dividend beyond a certain limit. It also affects the capital .

 Legal Requirements. In deciding on the dividend, the directors take
the legal requirements too into consideration. In order to protect the
interests of creditors an outsiders, the companies Act 1956 prescribes
certain guidelines in respect of the distribution and payment of dividend.
Moreover, a company is required to provide for depreciation on its fixed
and tangible assets before declaring dividend on shares. It proposes that
Dividend should not be distributed out of capita, in any case. Likewise,
contractual obligation should also be fulfilled, for example, payment of
dividend on preference shares in priority over ordinary dividend.
 Regularity and stability in Dividend Payment. Dividends
should be paid regularly because each investor is interested in the regular
payment of dividend. The management should, in spite of regular payment
of dividend, consider that the rate of dividend should be all the most
constant. For this purpose sometimes companies maintain dividend
equalization Fund. Developed by Dr IKRAM UL HAQ

 Firm should tailor their dividends policy to their long-term
investment opportunities to have maximum flexibility and
avoid financial frictions and cost of raising external funds.
 When they don’t have any specific investment opportunities
they invest in short term securities yielding nominal returns.

 Shareholders’ preference for dividends or capital gains may
depend on dividends and capital gains.
 The ownership concentration in a firm may define the
shareholders’ expectations.
 Closely held company where shareholders are small and
homogeneous and management usually knows the
expectations of shareholders.

 Where in widely held company, number of shareholders are very
large. So, they have diverse desire regarding dividends and capital
gains.
 Small shareholders are not frequent purchasers of the shares. They
have small numbers of shares in few companies with the
expectations of dividend income.
 Retired and old persons will purchase shares from their regular
income so that they choose regular and liberal dividends paying
company.
 Wealthy investors are much concerned about with the dividend
policy followed by a company. They have definite way of
investment policy to maximize their wealth and minimize taxes
 Institutional investors purchase large blocks of shares to hold them
for relatively long periods of time.

 Legal restrictions
 Liquidity
 Financial Conditions
 Access to Capital Market
 Restrictions in Loan Agreement
 Inflation
 Control

 LEGAL RESTRICTIONS
 Evolve within legal framework
 The directors are not legally compelled to declare dividend
 LIQUIDITY
 Payment of dividend means cash outflow.
 There might be adequate earning but insufficient cash to pay
 Cash position and overall liquidity > ability to pay dividend
 Two conditions of firm :- Mature firm & growing firm

 FINANCIAL CONDITION AND BORROWING CAPACITY
 It is depends on its use of borrowings and interest charges
payable .
 Higher degree of FL makes company vulnerable to change in
earnings, there more base is on equity.
 Steady growing firm cash flows and less investment
opportunities , might follow high dividend policy in spite of
having debt
 Growing firm to pay dividend borrow funds. This might not be
sound. It reduces financial flexibility.

 ACCESS TO CAPITAL MARKET
 Company if insufficient with cash can also pay dividend
through raising debt and equity in capital market.
 Good goodwill in market would easily raise fund
 If the company has an easy access to market it provides
flexibility to the management in paying dividend as well as
meeting corporate obligations.
 Soundness of the company cash position determines it access
to capital market.
 Thus, Ability to raise fund in capital market > ability to pay
dividend even if its not liquid.

 RESTRICTION IN LOAN AGREEMENT
 Terms and conditions of lender can also restrict the dividend
policy in order to safeguard their interest they would be
receiving in future, who has lower profitability and liquidity.
 If higher is the debt , or If liquidity is low prohibition can be
there.
 When the restriction put, the company is forced to retain
earnings and have low payout.
 INFLATION
 Accounting is based on historical cost, Thus

 CONTROL
 The management control over the company can also influence
dividend policy. Large dividend affects cash position. As a
result, the company will issue new shares to raise fund to
finance its investment. The power of existing will be diluted if
they don’t buy additional shares issued.
 Under these conditions, the payment of dividend may be
retained to finance the firm investment opportunities.

 Stability of dividends is considered a desirable policy by the
management of most companies in practice. Many surveys have
shown that shareholders also seem generally to favor this policy and
value stable dividends higher than the fluctuating ones.
 Stability of dividends also means regularity in paying some
dividend annually , even though the amount of dividend may
fluctuate over the years ,and may not be related with earnings.
 There are a number of companies, which have records of paying
dividend for a long, unbroken period. More precisely, stability of
dividends refers to the amounts paid out regularly.

 Constant dividend per share or dividend rate
 Constant payout
 Constant dividend per share plus extra dividend

 A number of companies follow in India follow the policy of
paying a fixed rate on paid-up capital as dividend year,
irrespective of the fluctuations in the earnings.
 When the company reaches new levels of earnings and
expects to maintain them, the dividend rate may be increased.
 It is easy to follow this policy when earnings are stable.
However if the earning patterns of a company shows wide
fluctuations, it than becomes difficult to maintain such a
policy.

 In practice, when a company retains earnings in good years for
this purpose, it earmarks this surplus as dividend equalization
reserve.
 These funds are invested in current assets like trade able
(marketable) securities, so that they may easily be converted
into cash at the time of paying dividends in bad years.
 A constant dividend per share policy puts ordinary
shareholders at par with preference shareholders irrespective
of the firm’s investment opportunities or the preferences of
shareholders.

 The ratio of dividend to earnings is known as payout ratio.
 Some companies may follow a policy of constant payout ratio
i.e. paying a fixed percentage of net earnings every year .
 With this policy the amount of dividend will fluctuate in direct
proportion to earnings.
 If a company adopts a 40 % payout ratio, then 40% of every
rupee of net earnings will be paid out.

 This policy is related to a company’s ability to pay dividends.
If the company incurs losses, no dividends shall be paid
regardless of the desires of shareholders.
 At any given payout ratio, the amount of dividends and the
additions to retained earnings increase with increasing
earnings and decrease with decreasing earnings.
 This policy does not put any pressure on a company’s liquidity
since dividends are distributed only when the company has
profits.

 For companies with fluctuating earnings, the policy to pay a
minimum dividend per share with a step-up feature is
desirable .The small amount of dividend per share is fixed to
reduce the possibility of ever missing a dividend payment.
 By paying extra dividend( a number of companies in India pay
an interim dividend followed by a regular, final dividend) in
periods of prosperity, an attempt is made to prevent investors
from expecting that the dividend represents an increase in the
established dividend amount.

 This type of policy enables a company to pay constant amount
of dividend regularly without a default and allows a great deal
of flexibility for supplementing the income of shareholders
only when the company’s earnings are higher than the usual,
without committing itself to make larger payments as a part of
the future fixed dividend.
 Certain shareholders like this policy because of the certain
cash flow in the form of regular dividend and the option of
earning extra dividend occasionally.

 Resolution of Investors
 Investor’s desire for current income
 Institutional investor’s requirements
 Raising additional finances

 The greatest danger in adopting a stable dividend policy is
that once it is established , it cannot be changed without
seriously affecting the investors attitude and the financial
standing of the company
 Missing of dividend payment in a year will effect on investors
more than the failure to pay a dividend with unstable dividend
policy

 A cut in dividend = A cut in salary
 The companies with stable dividend policy create a ‘clientele’
that depends on dividend income to meet their living and
operating expenses.
 When a company fails to pay a dividend , it does not have a
depressing effect on investors as a failure to pay a regular
dividend does.

 He found out that firms generally think in
terms of proportion of earnings to be made
out investment requirements are not
considered for modifying the patterns of
dividend behavior. Thus firms generally have
target payout ratios in view while determining
change in dividend per share.

DIV1 = pEPS1
The dividend change
Div1-Div0 = pEPS1 – Div0
Lintner suggested the following formula:
Div1-Div0 = b(pEPS1-Div0)

 Companies mostly pay dividends in cash.
 A company should have enough cash while declaring dividend in
its absences arrangement should be made to borrow fund.
 Same way, when the company follows a stable dividend policy, it
should prepare a cash budget for the coming period to indicate the
necessary funds, which would be needed to meet the regular
dividend payments of the company.
 It is relatively difficult to make cash planning in anticipation of
dividend needs when an unstable policy is followed.
 The cash account and the reserve account of a company will be
reduced when the cash dividend is paid.
 Thus, both the total asset and the net worth of the company are
reduced when the cash dividend is distributed.
 The market price of the shares drops in most cases by the amount
of the cash dividend distributed. Developed by Dr IKRAM UL HAQ

 Bonus shares is the distribution of shares free of cost to the existing
company.
 In India, bonus shares are issued in addition to the cash dividend
and not in lieu of cash dividend. Hence companies in India may
supplement cash dividend by bonus issues.
 The bonus shares are distributed proportionately to the existing
shareholder. Hence there is no dilution of ownership.
 The declaration of bonus shares will increase the paid up share
capital and reduce the reserve and surplus of the company.
 The total net worth (paid up capital + surplus) is not affected by the
bonus issue.
 In fact, a bonus issue represents a recapitalization of reserve and
surplus.
 It is merely an accounting transfer from reserves and surplus to
paid-up capital.

For shareholders:
1) Tax benefits
2) Indication of higher future profits.
3) Future dividends may increase
4) Psychological value

 For company:
1) Conservation of cash
2) Only means to pay dividends under financial
difficulty and contractual restrictions.
3) More attractive share price

1) Shareholders wealth remains unaffected
2) Costly to administer
3) Problem of adjusting Earning Per Share and Price Earning
Ratio.

 When the prices of shares fall, the company may want to
reduce the number of its share outstanding to increase the
market price.
 The reduction of the number of outstanding shares by
increasing per share par value is known as a reverse split.

 A share split is a method to increase the number of outstanding
shares through a proportional reduction in the par value of the
share and thus shareholders total funds remain unaltered.

 The buy buck of shares is the repurchase of its own shares by
a company.
 Until recently the buy buck of shares by companies in Pakistan
was prohibited
 As a result, a company in Pakistan can now buy buck its own
shares.

1) A company buying back its shares will not issue fresh capital,
except bonus issue, for the next 12 months.
2) The company will state the amount to be used for the
buyback of shares and seek price approval of shareholders.
3) The buyback of shares can be affected only by utilizing the
free reserves, viz., reserves not specifically earmarked for
some purpose.
4) The company will not borrow funds to buy back shares.
5) The shares bought under the buyback schemes will be
extinguished and they cannot be reissued.

 There are two methods of the shares buyback in Pakistan.
1) A company can buy its shares through authorized brokers on
the open markets. The reason for the buy buck was that the
company wanted to signal to the shareholders that it would
reward its shareholders by returning surplus cash to them.
2) The company can make a tender offer, which will specify the
purchase price, the total amount and the period within which
shares will be bought back.

 Buy back will be financially beneficial for the company, the
buying shareholders and the remaining shareholders .
 As we have explained, the bought up shares will be
extinguished and will not be reissued. This will permanently
reduce the amount of equity capital and the number of
outstanding shares.
 If the company distributed surplus cash and it maintains its
operating efficiency, EPS will increase.
 The share price will increase as P/E ratio is expected to remain
same after the buy back.
 Due to this companies with existing low debt-equity ratio
will be able to move to their target capital structure.

Return of surplus cash to shareholders
Increase in the share value
Increase in the temporarily undervalued share price
Achieving the target capital structure
Consolidating control
Tax savings by companies
Protection against hostile takeovers

 Not an effective defense against takeover
 Shareholders do not like the buyback
 Loss to the remaining shareholders
 Signal of low growth opportunities.

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