Contents :
- Meaning of Dividend.
- Background of Dividend Policy.
- The Dividend Payment Time Line.
- Forms / Types of Dividend.
- Measures of Dividend.
- Meaning of Dividend Policy.
- Factors Influencing Dividend Decision.
What is Dividend ?
From the viewpoint of the shareholders, dividends represent compensation for postponing consumption. The dividend policy of the firm relates to various decisions on payments of dividend. The firm regards dividend decision as a major aspect of the financing decision of the firm. The critical question then is whether profits should be distributed as dividends or retained within the firm to finance future expansion and growth.
Meaning of Dividend
A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock or other property. It is a payment made by a corporation to its shareholders. Usually these payouts are made in cash (called "cash dividends"); but sometimes companies will also distribute stock dividends, whereby additional stock shares are distributed to shareholders. Stock dividends are also known as stock splits.
Background of Dividend Policy
In this section, we consider three issues. First, how do firms decide how much to pay in dividends, and how do those dividends ally get paid to the stockholders? We then consider two widely used measures of how much a firm pays in dividends, the dividend payout ratio and the dividend yield. We follow up by looking at some empirical evidence on firm behavior in setting and changing dividends, the time line associated with dividend payment and defines different types of dividends.
The Dividend Payment Time Line
Dividends in publicly traded firms are usually set by the board of directors and paid out to stockholders a few weeks later. There are several key dates between the times the board declares the dividend until the dividend is actually paid.
1) The first date of note is the dividend declaration date, the date on which the board of directors declares the dollar dividend that will be paid for that quarter (or period). This date is important because by announcing its intent to increase, decrease, or maintain dividend, the firm conveys information to financial markets. Thus, if the firm changes its dividends, this is the date on which the market reaction to the change is most likely to occur.
2) The next date of note is the ex-dividend date, at which time investors must have bought the stock to receive the dividend. Because the dividend is not received by investors buying stock after the ex-dividend date, the stock price will generally fall on that day to reflect that loss.
3) At the close of the business a few days after the ex-dividend date, the company closes its stock transfer books and makes up a list of the shareholders to date on the holder of record date. These shareholders will receive the dividends. There should be generally be no price effect on this date.
4) The final step involves mailing out the dividend checks on the dividend payment date. In most cases, the payment data is two to three weeks after the holder-of-record date. Although stockholders may view this as an important day, there should be no price impact on this day either. Following Figure presents these key dates on a time line.
Types of Dividends
There are several ways to classify dividends. First, dividends can be paid in cash or as additional stock. Stock dividends increase the number of shares outstanding and generally reduce the price per share. Second, the dividend can be a regular dividend, which is paid at regular intervals (quarterly, semi-annually, or annually), or a special dividend, which is paid in addition to the regular dividend. Finally, firms sometimes pay dividends that are in excess of the retained earnings they show on their books. These are called liquidating dividends and are viewed by the Internal Revenue Service as return on capital rather than ordinary income. As a result, they can have different tax consequences for investors.
Forms / Types of Dividend :
Dividend may be declared in different forms. These forms are explained below :
1) Cash Dividend:
This is the most popular form of dividend. In cash dividend, shareholders are paid dividend in cash. Sometimes it is supplemented by bonus (stock dividend). The company must have sufficient cash balance in its bank. account otherwise, it would have to arrange funds for the payment of dividend. If the company follows the 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. But if unstable policy of dividend is followed cash planning in anticipation of dividend is relatively difficult.
The case dividend may take two forms. They are as follows :
a) 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 is generally paid in cash as a percentage of paid up capital Sometimes, it is paid per share. No dividend is paid on calls in advance or calls in arrears. The company is however, authorized to make provisions in the articles prohibiting the payment of dividend or shares having calls in arrears.
b) Interim Dividend :
If Articles so permit, the directors may decide to pay dividend at any time between the two Annual General Meetings before finalizing the accounts is generally declared and paid when Company has earned heavy profits or abnormal profits during the year and directors wish 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 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.
2) 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.
3) 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 of debentures if other companies held by the company as investment. 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 investments which they founds were not good. Such dividend was allowed before passing of The Companies (Amendment) Act 1960, but thereafter this unhealthy practice was stopped.
4) Bond Dividend :
As in scrip dividends, dividend is not paid immediately in bond dividend. Instead, the company promises to pay dividends at a future date. Dividends are paid in the form of debentures or bonds or notes for a long-term period bearing interest at fixed rate. The effect of such dividend is the same as that of paying dividend in scrips. The shareholders become the secured creditors if the bonds have lien on assets.
5) Property Dividend :
Sometimes, dividend is paid in the form of asset instead of payment of dividend in cash. The distribution of dividend made whenever the asset is no longer required in the business such as investment or stock or finished goods.
But, it is to be noted 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.
Measures of Dividend
Dividend measures are useful to measure dividend performance of a share when compared to similar companies or markets. Dividend yield and dividend pay out are the two relative measures of dividend payment. They are explained below:
a) Dividend Yield :
A dividend can be expressed as a percentage of the share price. This is called the yield. It is the annual return one receives from holding a share. The dividend yield or the dividend-price ratio on a company stock is the company's annual dividend payments divided by its market cap, or the dividend per share divided by the price per share. It is often expressed as a percentage. Its reciprocal is the Price/Dividend ratio. Yield can be an important consideration when investing as some companies have a policy of maximizing their dividend pay-outs, whereas others are more concerned to retain all or most of the profits for reinvestment this then relates to one's investment goals. This is not a measurement of the total potential for growth because it does not capture the rise or fall in the share price but it is an important component of the total return.
Types of Dividend Yield :
1) Preferred Share Dividend Yield :
Dividend payments on preferred shares are stipulated by the prospectus. The company will typically refer to a preferred share by its initial name which is the yield on its original price - for example, a 6% preferred share. However, the price of preferred shares varies according to the market so the yield based on the current price fluctuates. Owners of preferred shares calculate multiple yields to reflect the different possible outcomes the life of the security.
Current yield is the $Dividend / Pfd share current price.
Since the share may be purchased at a lower (higher) cost than its final redemption value, holding it to maturity will result in a capital gain (loss). The annualized rate of gain is calculated using the Present value of a dollar calculation. ('PV' is the current stock price. 'FV' is the redemption value. 'n' is the number of years to redemption. Solve for the interest rate 'P.) The yield to maturity is the sum of this annualized gain (loss) and the current yield.
There are other possible yields discussed at Yield to maturity.
2) Common Share Dividend Yield :
Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to holders of common stock are set by management, usually in relation to the company's earnings. There is no guarantee that future dividends will match past dividends even be paid at all. Due to the difficulty in accurately forecasting future dividends, the most commonly-cited figure for dividend yield is the current yield which is calculated using the following formula:
Current Dividend Yield =
Most Recent Full-Year Dividend
----------------------------------------------
Current Share Price
For example, take a company which paid dividends totaling $1 per share last year and whose shares currently sell for $20. Its dividend yield would be calculated as follows:
Current Dividend Yield =
Most Recent Full Year-Dividend
-----------------------------------------------
Current Share Price
$1
--------
$ 20
= 0.05
= 5%
Rather than use last year's dividend, some try to estimate what the next year's dividend will be and use this as the basis of a future dividend yield Such a scheme is used for the calculation of the FTSE UK Dividend+Index[1]. It should be noted that estimates of future dividend yields are by definition uncertain.
Related measures :
The reciprocal of the divided yield is the Price/Dividend ratio. The dividend yield is related to the earnings yield via:
a) Earnings yield = dividend yield * dividend cover.
b) Dividend yield = earnings yield * dividend payout ratio.
b) Dividend Payout Ratio :
Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends :
The part of the earnings not paid to investors is left for investment to provide for future earnings growth. Investors seeking high current income and limited capital growth prefer companies with high Dividend payout ratio. However investors seeking capital growth may prefer lower Payout Ratio because capital gains are taxed at a lower rate. High growth firms in early life generally have low or zero payout ratios. As they mature, they tend to return more of the earnings back to investors. Note that dividend payout ratio is a reciprocate ratio to dividend cover, which is calculated as EPS/DPS. Dividend payout ratio is used in valuation as a way of estimating dividends in future periods. It is also used to compute the retention ratio which measures the proportion of earnings reinvested back in the firm. Firms with retention ratios generally have higher growth rates.
Impact of Buybacks :
Some companies chose stock buybacks as an alternative to dividends, in such cases this ratio becomes less meaningful. One way to adapt it using an augmented payout ratio :
Augmented Payout Ratio = (Dividends + Buybacks) Net Income for the same period.)
What is Meant by Dividend Policy ?
A dividend is that part of distributable profit of a company which is distributed among the shareholders. The dividend is formally declared at the annual general meeting of the company. It may be paid at a fixed rate or it may vary according to the financial position of the company. Generally, the dividend on preference shares remains fixed and on the equity shares varies. The dividend is declared out of the distributable profit. No dividend will be declared if the company has not made any profit or has not distributed its profit. The shareholders cannot compel a company to declare dividend. It is the absolute right of the board of directors to recommend the dividend, because directors are the persons who control the management and financial position of the company. They are required to prepare a report on the balance sheet of the company at the end of financial year, in which they may or may not recommend the declaration of dividend keeping in view the financial requirements of the company.
Meaning of Dividend Policy
The economic soundness of a company is generally judged by the amount of dividend declared and paid by it to the shareholders. It affects its goodwill among the shareholders and the prospective shareholders. Dividend is a part of profits distributed among the shareholders. The basic question before the Board of Directors is how much profits should be divided among shareholders as dividend and how much to be retained in the business as reserves to meet the future contingencies and for expansion of business Both future expansion and distribution of dividend are desirable but two aims are in conflict. Hence, allocation of earnings between dividends and retained earnings is an essential part of management functions. It requires a sound dividend policy to be followed by the corporation.
Definition of Dividend Policy
Weston and Brigham :
"Dividend policy determines the division of earnings between payments to shareholders and retained earnings."
Variables/Factors Influencing Dividend Decision
To formulate dividend policy some factors are to be considered as they influence dividend decisions. These factors may be categorized in two broad groups. They are a) External Variables/Factors b) Internal Variables/Factors. They are explained below:
a) External Variables/Factors :
1) 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 constant dividend policy than those having an even flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating than those dealing in luxuries or fancy goods.
2) State of Capital Market :
If the market position is comfortable in the country and the funds may be raised from different sources without much difficulty, the management may tempt to declare a high rate of dividend to attract the investors and maintain the existing shareholders contrarily, if there is a slump in the stock market and the shareholders are not interested in making the investment in securities, the management should follow a conservative dividend policy by maintaining a low rate of dividend and ploughing back a sizable portion of profits to face any contingency. Likewise, if the term lending financial institutions advance loans of stiffer items, it may be desirable to rely on internal sources of financing and accordingly conservative dividend policy should be pursued.
3) Taxation Policy:
High taxation reduces the earnings of the companies and consequently the rate of dividend is lowered down. Sometimes, Government levies dividend tax on distribution of dividend beyond a certain limit. It also affects the rate of capital formation.
4) Government Policies:
The earning capacity of the enterprises 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 spares of business activity as was done by the Government of India in emergency. The dividend policy has to be modified or formulated accordingly.
b) Internal Variables/Factors :
1) Age of a Corporation:
Age of the corporation counts much in deciding the dividend policy. A newly- established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while an older company can formulate a clear cut and more consistent policy regarding dividend.
2) Access to Capital Market:
A company having stable and high earning will have ready access to capital market. It is true in the case of large and well established ventures. This may encourage the management to formulate liberal dividend policy to pay but size-able portion of the income. However, if it is difficult for a company to access to external sources of financing, the management should restrict dividend payments to retain larger earnings for financing profitable projects.
3) Liquidity Position of Company:
Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm, the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which, in turn, determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be preferred and if cash position is good, company can distribute cash dividend.
4) 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 allowing 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 emphasis to distribute higher dividends in cash immediately.
5) Repayment of Debts :
A company having debts are vowed to a high rate of retention earnings, unless some other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders put restrictions on the dividend distribution till such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to honour such restrictions and to limit the rate of dividend pay-out.
6) 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 programmes. 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.
7) Policy of Control :
Policy of control is another determining factor in dividend decisions. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So, they prefer to meet the needs through retained earnings. If the directors do not bother about the control of affairs, they will follow a liberal dividend policy.
8) 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 good reserves for contingencies. Higher rates of dividend can be used as a tool for making 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.
9) Past Dividend :
While formulating the dividend policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rate. If it has been abnormally increased, the shares will be subjected to speculation. In a new concern, the company should consider the dividend of the rival organisation.
10) Time for Payment of Dividend :
When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is therefore, desirable to distribute dividend at a time when it is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances.