What is Dividend Policy? Objective, Factors, Definition, Dividend Decision

What is Dividend Policy?

Dividends are paid out of the PAT generated by a firm. Dividend payment is a cash drain for firms as it is a cash out­ flow. Payment of dividends reduces a firm’s earnings, which may make it necessary for the firm to seek external financing in order to meet its operating and investment decisions.

Retained earnings are the earnings left with the firm after it has met all its expenses and obligations.

It can be expressed as follows:

Retained earnings (reserve and surplus) = Profit after tax − Dividend payments − Provisions

Firms use their retained earnings for further investments and internal plough-backs. To enhance its value in the long run, a firm needs to continuously invest in new opportunities and in the existing business.

Firms prefer cash generated on their own over external funding as the cost of internal funds is less than the cost of externally borrowed funds. Insufficient profit and the burden of high dividend payouts may affect the judi­cious appropriation of net profits, resulting in a reduction of generated cash flows and an increase in external borrowings.

When profitable investment opportunities exist and earnings are limited, a firm has to do away with either dividend pay­ments or the investment decision. However, when both are to be met, the firm has to procure funds externally. Many a time, firms opting for large investments forego dividend payments for that period in order to avoid external financing.

Firms such a Infosys, which have sufficiently large self-generated profits, are able to finance their operating, investing and dividend activities without raising any debt. In the business world, most firms prefer to pay dividends to their investors as a sign of goodwill. Even growing firms such as Microsoft, are compelled to give in to the pressure of investors to pay dividends. Dividend policy is an essential part of every firm. A firm has to determine the trade-off between the return and the risk associate

Once a company makes a profit, management must decide on what to do with those profits. The management could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. The part of the profit that is distributed is termed as dividend.

The ratio of the actual distribution or dividend, and the total distributable profits, is called dividend payout ratio. Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets.

The decision about management of profit depends on the current and future situation of the company. It also depends on the preferences of investors and potential investors.

Objectives of Dividend Policy

A finance manager may treat the dividend decision in the following two ways:

• As a long term financing decision- When dividend is treated as a source of finance, the firm will pay dividend only when it does not have profitable investment opportunities. On the other hand, the firm can also pay dividend and raise an equal amount by the issue of shares but this does not make any sense.
• As a wealth maximisation decision- Payment of current dividend has a positive impact on the share price. So, in order to maximise share price, the firm must pay more and more dividends.

Factors Affecting Dividend Policy

• Dividend payout ratio: It refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm.
  
  The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm’s shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm’s owners and providing sufficient funds to finance growth. These objectives are interrelated.
  
  
  
• Stability of dividends: Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:
  
  • a. Constant dividend per share: A company may follow a policy of paying a certain fixed amount per share as dividend. For example, on a share of face value of Rs 200, firm may pay a fixed amount say Rs 10 as dividend. This will be paid year after year irrespective of level of earnings.
    
    
  • Constant dividend payout ratio: Under this policy a firm pays a constant percentage of net earnings as dividend to the shareholders. In each dividend period.
    
    
  • Constant dividend per share plus extra dividend: Using this policy, a firm usually pay affixed dividend to the shareholders and in a year of good performance, an additional or extra dividend is paid over and above the regular dividend.
    
    
• Legal, contractual and internal constraints and restrictions: Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds.
  
  These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, and financial requirements, availability of funds, earnings stability and control.
  
  
  
• Owner’s considerations: The dividend policy is also likely to be affected by the owner’s considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership. This is an external factor as companies cannot control what investors want or expect from their industry.
  
  
• Capital market considerations: The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
  
  
  
• Inflation: With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipment and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.

Dividend Decision

The dividend decision is taken by the firm’s board of directors and is based on the current financial performance and future activities of the firm. The board normally holds quarterly or semi-annual dividend meetings. To save companies from going bankrupt, the Indian Companies Act states that dividends should be paid out of the surplus revenue that a firm gener­ ates, and not by selling off its assets. When generated profits are not adequate, firms may abstain from paying any dividends.

The dividend amount is generally fixed with the scope for adjustments, which may be made as the need arises. Most firms have a specific policy on dividend payments.

A few terms associated with the payment of dividends are discussed here:

• The declaration date is the date on which the firm’s board of directors issues a statement declaring a dividend. For example, if on 30 January 2005 Company X announces that it will pay a dividend on 20 February of the same year, 30 January 2005 will be the declaration date.
  
  
• The date on which the company opens the ownership books to determine who will receive dividends is known as the holder-of-records date. At the close of busi­ ness, on the holder-of-record date, the company closes its stock-transfer book and makes a list of its existing shareholders till that date. If the company is not officially informed of a transaction of its stock and the name of a new shareholder before 5 PM on the record date, the new shareholder does not get the dividend.
  
  
• The ex-dividend date is the date on which the right to the next dividend no longer accompanies a stock. The ex-dividend date helps avoid conflict regarding dividend payments to existing shareholders. Usually, the right to the dividend remains with the stock until two days before the holder-of-record date. Whoever buys the stock on or after the ex-dividend date does not get the dividend.
  
  
• The payment date is the actual date when the firm mails the dividend amount to the shareholders on its records.