What is Dividend Policy? Types, Determinants, Theories

What is Dividend Policy?

The company’s dividend policy is a set of guidelines for dividend distribution prepared by the board of directors of a company. The policy establishes guidelines for profit distribution to shareholders. It also specifies how often and in what form dividends will be paid out.

A company’s dividend policy is its choice of how to distribute dividends to its shareholders. It is a financial decision that comprises determining the dividend payout ratio, dividend frequency and whether or not dividends should be paid at all.

Developing a dividend policy is difficult for a company’s board since various investors have varied perspectives on current cash dividends and future capital gains. Another point of contention is the extent to which dividends affect the share price. The dividend dilemma is a term that refers to the divisive character of a payout policy.

Several models have been created to assist businesses in analysing and evaluating the ideal dividend policy.

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What is Dividend?

A dividend is a payment made by a company to its shareholders in exchange for its earnings. When a company makes a profit or has a surplus, it can pay a dividend to its shareholders. Any money that is not dispersed is put back into the company (called retained earnings). A company’s profit for the current year as well as retained profits from prior years are available for distribution; however, a company is generally forbidden from paying a dividend from its capital.

If the firm has a dividend reinvestment plan, the amount can be distributed to shareholders in cash (typically a deposit into a bank account) or by issuing additional shares or repurchasing existing shares. In some situations, the assets may be distributed. The dividends paid by the corporation do not qualify for a tax deduction.

Dividend Payment to Equity Shareholders

The total value of all dividends given when a corporation delivers cash dividends to its shareholders reduce the stockholders’ equity; nevertheless, the impact of dividends varies based on the kind of dividends a firm pays. When compared to cash dividends, stock dividends do not have the same impact on shareholder equity.

How Dividends Are Paid

Typically, dividends are given in cash, extra stock shares or a mix of both. When the corporation distributes a dividend in cash, each shareholder receives a precise dollar amount based on the number of shares they currently own. Therefore, a corporation that announces a Rs 1 dividend pays Rs 1,000 to a shareholder with 1,000 shares.

Shareholders get more shares in a stock dividend based on their present ownership interest. The shareholder obtains an extra 100 shares if the corporation in the aforementioned case instead chooses to distribute a 10% stock dividend. Some businesses provide shareholders the option to reinvest a cash dividend by acquiring more shares of stock at a discount.

Dividend Payment to Preference Shareholders

A dividend that is allocated to and paid on a company’s preferred shares is known as a preferred dividend. Preferred dividend claims take priority over claims to dividends paid on ordinary shares if a corporation is unable to pay all dividends.

How to Calculate Preferred Dividend

The preferred stock prospectus for each issue of preferred stock includes information on the equity’s dividend yield and par value. The total yearly preferred dividend is equal to the dividend rate times the par value. The issuer divides the total preferred dividend by the number of periods to get an approximation of the installment payment if the entire dividend to be received is distributed in installments, such as in quarters.

A company’s capacity to pay the needed sum that will be owed to the holders of its preferred stock shares is gauged by the preferred dividend coverage ratio. Shares of preferred stock have a dividend that is predetermined and unchangeable. When a firm is in good condition, its preferred dividend coverage ratio will be high, suggesting that it won’t have any trouble covering its debt in preferred dividends.

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Kinds of Dividends

A dividend is a distribution of a portion of a company’s earnings to a class of shareholders chosen by the board of directors of the firm. As long as they possess the shares before the ex-dividend date, common shareholders of dividend-paying firms are usually eligible. There are several types of dividends that a corporation may pay to its shareholders:

Dividends in Cash

It is the most prevalent variation. For each share, cash dividend is paid to the shareholders. On the day of declaration, the board of directors announces the dividend payment. The dividends are distributed to those shareholders who were stockholders of the corporation on the date of the records.

The record date and the ex-dividend date are two crucial elements to understand. The dividends are paid on the payment day. However, to pay cash dividends, the corporation must have positive retained earnings and sufficient cash.

Bonus Participation

Stock dividend is also known as a bonus share. Each equity shareholder receives a set number of extra shares based on the number of shares the shareholder previously owned. An investor who wants a monetary return on their investment can sell it on the secondary market. ‘Capitalisation of profits’ is the word used to describe this.

Repurchase of Shares

When a corporation buys back its stock from the market, it decreases the number of outstanding shares. This is viewed as an alternative to paying dividends since cash is returned to investors in a different method.

Real Estate Dividends

The property dividend is a payment made by the corporation in the form of assets. This equipment, inventory, vehicle or any other item might be an asset. While issuing this, the asset’s value must be restated at a fair value.

Scrip Dividends

It is a promissory note that promises to pay the stockholders at a later date. When the corporation does not have enough finances to issue a bond, this kind is employed.

Dividend Liquidation

Liquidating dividends occur when a corporation pays out the initial money invested by equity owners as a dividend. It is a hint for the investors that the firm is about to shut down or liquidate in the near future.

Different Models for Analysing Dividends

To estimate the price of a company’s shares, the Dividend Discount Model (DDM) is utilised. When all future dividend payments are discounted back to the present, the present value of the stock equals the present value of all future dividend payments.

The stock is cheap and qualifies for a ‘buy’ choice if the present value is determined using the DDM which is higher than the current trading price. Here, we are discussing some of the models for analysing dividends.

Discount Model for Dividends (DDM)

Every company aims to generate money by providing services or manufacturing things. These gains are frequently distributed to shareholders as dividends. According to the Discount Dividend Model, a company’s worth is equal to the present value of all dividends it will ever pay to its shareholders.

The strategy is based on the time value of money principle. For example, if Mr. Amit can acquire 100 euros now or in a year, he can rather have it now since he will have a year to earn a return on it.

Dividend Calculation

It might be difficult to predict future dividend distributions. It entails making educated guesses or attempting to spot and quantify patterns based on historical dividend payments. Analysts typically assume a constant growth rate for the firm and consider it as though it exists in eternity (a regular stream of equal cash flows with no end). The growth rate is often calculated using previous data.

Factor of Discount

Shareholders are exposed to the possibility of a drop in the value of their company’s shares. As a result, they anticipate a profit (compensation). The expected reward for assuming the risk of ownership is represented by a company’s cost of equity.

The Capital Asset Pricing Model (CAPM) or the Dividend Growth Model (DGM) may both be used to determine the discount factor. The effective discounting factor for a company’s dividends is calculated using the rate of return minus predicted yearly growth. DDM tells us how much we should pay for a stock if we want to make a profit.

Rate of Increase

The growth rate may be calculated by multiplying the return on equity by the retention rate (the opposite of the dividend payout ratio). Because the dividend is paid from the company’s earnings, it cannot exceed it. This implies that the stock’s rate of return must exceed the predicted dividend growth rate for future cash flows.

Otherwise, you will end up with an unsustainable paradigm with negative stock prices, which is impossible to achieve in real-world settings. Growth improves the nominal value of the dividend distribution, while the time value of the money idea reduces its buying power, as we can see.

DDM Variable Growth Rate

A Multi-Stage Dividend Discount Model or Multi-Stage DDM is the most realistic, since it predicted various stages of the company’s growth. Analysts frequently assume three stages, i.e., when a firm is young and appealing to investors, it will have a high growth rate at first, as the company matures, it will have a reduced growth rate.

Growth Rate That is Steady and Mature

Each phase may be calculated separately as a constant-growth DDM and then added together. We must keep in mind that these future phases must be discounted to their current worth. The following are the benefits of the DDM model:

• The approach has a strong theoretical foundation as well as a solid mathematical model.
  
  
• The DDM removes the possibility of subjectivity.
  
  
• Dividends can have an impact on the stock price. As a result, corporations tend to align them with the company’s essential KPIs, making our inputs less vulnerable to manipulation.
  
  
• Analysts feel that the DDM is best appropriate for companies that pay dividends; nevertheless, we may still use it to model organisations that do not disperse earnings to their shareholders by making assumptions about what dividend they can pay.

The DDM also has significant drawbacks. Some of them are as follows:

• The most common scenario assumes a constant annual growth rate, which is exceedingly implausible.
  
  
• Because the gap between the discount factor and the growth rate is so small, the model is vulnerable to input changes, little adjustments have a big impact.
  
  
• When used on small-dividend equities, the method tends to produce erroneous findings.
  
  
• The DDM is best suited for established, stable businesses; it is not appropriate for start-ups or businesses in the early stages of development.
  
  
• Because corporations strive for constant payouts and might occasionally utilise borrowed cash to deliver dividends, the model may not be representative of the company’s profitability.
  
  
• It is based on the idea that dividends are an accurate representation of cash flows delivered to shareholders.

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Types of Dividend Policies

The policy of the dividend distribution of a company dictates the number of dividends and the frequency at which the company pays to shareholders. When the company earns profits, it has to decide regarding how and where that profit will utilise. The company can either retain profits earned or else they can choose to distribute the same in the form of the dividends to its shareholders. There are different types of policies related to the dividend which the company can follow.

Four most prevalent types of dividend policies are:

Regular Dividend Policy

A regular dividend policy is a type of dividend policy in which the company follows a procedure to pay a dividend to its shareholders every year. When a company earns abnormal profits, it retains the extra profit and when the company is making losses in any year, then also it pays a dividend to its shareholders.

Companies having stable earnings and steady cash flows use this type of dividend policy. In this type of dividend policy, the dividend is paid regularly and the investors get dividends at a standard rate. Companies which practice regular dividend policy are usually low risk and, in most cases, the risk-averse investors put their money into the stocks of such companies. Usually, retired people and others who wish to create a steady stream of income invest in companies giving regular dividends.

Companies having regular income adopt this policy. One of the disadvantages of this type of dividend policy is that the quantum of dividends does not increase even if the market is flourishing. Such policies are helpful in creating confidence among the shareholders and stabilises the market value of shares. Such policy enhances the goodwill of the company.

Stable Dividend Policy

The simplest and most widely utilised dividend policy is a stable dividend policy. The policy’s purpose is to provide a consistent dividend distribution year after year. Investors receive a dividend regardless of whether the profits increase or decrease. The idea is to match the payout policy with the company’s long-term growth rather than the volatility of quarterly earnings. This method provides the shareholder with more assurance about the payout size and timeliness.

Under this form of dividend policy, the companies pay out a fixed proportion of profits as dividends to their shareholders every year. For example, if a corporation decides to give out 10% of its profits; then, regardless of the number of earnings, 10 % of earnings will be paid out as dividends every year. A set rate of dividend will be paid out to shareholders whether the firm achieves a profit of Rs 1 million or Rs 2,00,000.

Companies following this approach are considered risky by investors. The reason for this is that the amount of dividend varies depending on the degree of earnings. Companies divide their dividends into three parts. A steady dividend per share and a constant payout ratio are two parts of the dividend. The third part of dividend is a consistent rupee dividend with additional dividends.

The reserve fund established for this reason pays the continuous dividend per share. The dividend payout does not reflect the real company volatility. A steady dividend policy is defined by the target payout ratio. A regular dividend policy serves to stabilise the market value of shares.

Irregular Dividend Policy

This form of dividend policy specifies that the corporation is not obligated to pay a dividend to its shareholders. The dividend amount and rate is determined by the board of directors. They will decide on what they will do with the earnings. Their decision to pay a dividend has nothing to do with the company’s financial situation, whether it is profitable or not. It is contingent upon the board of directors’ decision.

Despite minimal or no profit, the board may opt to allocate profits. Investors will become more confident in the firm as a result and the company’s liquidity will improve. On the other side, the corporation might keep all or a major portion of its profits and pay no or few dividends. This might be done to boost the company’s growth by utilising retained earnings. Furthermore, this approach is used by businesses that have inconsistent cash flows and lack liquidity. Paying inconsistent dividends is risky for investors. Companies having this type of policy appeal to investors who enjoy taking risks.

No Dividend Policy

Under this form of dividend policy, the firm pays no dividend to its shareholders regardless of whether it is profitable or not. The payment percentage will be 0%. The whole profit will be kept by the corporation. It will reinvest in the company’s business strategy to develop it at a faster rate while avoiding concerns like liquidity. The corporation obtains cash from earnings for shareholders, which is a lower cost of financing, resulting in increased profit.

These practices are often employed by a startup or a corporation (such as Google or Facebook) that has already created confidence among investors. For startups, it aids in the expansion of their firm, resulting in total business development.

Shareholders invest in a firm that does not pay dividends in the hopes that their overall investment value will rise in tandem with the company’s development. For many, the increase in the value of their stock is more significant than the quarterly dividend. The class of investors that invest in these enterprises is often younger or middle-aged people who are not as reliant on a regular income.

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Determinants of Dividend Policy

Dividend declaration entails a number of legal and financial factors. From a legal standpoint, the basic rule is that dividends can only be paid out on gains that do not jeopardise capital in any manner. However, different financial variables make it difficult for management to make a choice about dividend distribution.

The following are some of the aspects to be considered:

Industry type

Industries with a constant flow of earnings may establish a more consistent dividend policy than those with an uneven flow of income. Public utilities, for example, are in a much better position than industrial firms to adopt a relatively set dividend rate.

Corporation’s age

Newly started businesses must devote the majority of their earnings to plant improvements and expansion, but older businesses with more earnings history can create clear dividend policies and potentially be more generous in their dividend distribution.

Size of the distribution of shares

A closely held corporation is more likely to obtain shareholder approval for dividend suspension or a conservative dividend policy. However, a corporation with a big number of dispersed stockholders would have a tough time obtaining such approval. Dividend reductions are possible, but only with the cooperation of shareholders.

Additional capital required

The extent to which profits are reinvested in the business has a significant impact on dividend policy. The income could be set aside to cover increasing working capital needs or future expansion.

Business cycles

During the boom, wise company management accumulates sufficient reserves to weather the inflationary period’s subsequent catastrophe. Higher dividend rates are utilised to advertise securities in a market that is otherwise depressed.

Policy shifts in the government

The rate of dividends declared by corporations in a specific industry or across all realms of commercial activity is often capped by the government. In July 1974, the government imposed temporary limitations on the payment of dividends by firms by amending the Indian Companies Act, 1956. In 1975, the limitations were lifted.

Profits trends

To determine the company’s typical earning position, the company’s profit pattern should be extensively investigated in the past. The trend of overall economic conditions should be taken into account when calculating average earnings. Only a cautious dividend strategy may be considered appropriate if a slump is on the horizon.

Fiscal policy

Dividends are impacted both directly and indirectly by corporate taxes: directly, since they diminish the after-tax earnings available to shareholders and indirectly because dividend distributions beyond a particular threshold are taxed. In the hands of shareholders, the amount of the announced dividend is now tax-free.

Requirements for the future

Profit accumulation becomes important to protect the firm from unforeseen events (or risks), fund future business development and modernise or replace the enterprise’s equipment. The management should decide the opposing claims of dividends and accumulations fairly.

Cash position

If the company’s operating capital is low, a liberal cash dividend policy cannot be implemented. Dividends must be paid to members in the form of bonus shares rather than cash.

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Theories of Dividend Policy

When other contributing variables are maintained constant, the value of a company is assumed to be a function of dividend decision under a dividend theory. There are opposing points of view on the impact of dividend decisions on the company’s value and cost of capital.

Dividends and share price growth are the two ways in which wealth can be provided to shareholders. There is an interaction between dividends and share price growth: if all earnings are paid out as dividends, none can be reinvested to create growth, therefore, all profitable companies have to decide on what fraction of earnings they should pay out to investors as dividends and what fraction of earnings should be retained.

Irrelevance Theories of Dividend

Dividend irrelevance hypothesis states that dividends have no impact on the stock price of a firm. A dividend is a financial payment paid to shareholders from a company’s profits as a reward for investing in the firm. Dividends, according to the dividend irrelevance argument, might impair a firm’s capacity to compete in the long run since the money would be better spent reinvested in the company to produce profitability.

Residual Theory of Dividend

This dividend policy is related to the residual theory. It asserts that a corporation should always invest in initiatives with a positive Net Present Value (NPV) and then give out any excess income as dividends.

Modigliani and Miller Approach

The capital structure irrelevance hypothesis is advocated by the Modigliani and Miller approach to capital theory, which was developed in the 1950s. This shows that a company’s capital structure has no impact on its valuation. The market value of a company is unaffected by whether it is heavily leveraged or has a low debt component. Rather, the market value of a corporation is completely determined by its operational income.

The Modigliani and Miller (M&M) approach have similar underpinnings to the Net Operating Income (NOI) Approach. Apart from the risk associated with the investment, the operational revenue impacts the market value of the business, according to the M&M approach. According to the notion, the firm’s worth is unaffected by the capital structure or financing decisions it makes.

According to the M&M approach, the value of a leveraged company (one with a mix of debt and equity) is the same as the value of an unleveraged company (a firm that is wholly financed by equity). If the operational profit margins and prospects are the same. To put it another way, purchasing shares in a leveraged company costs the same as buying shares in an unleveraged company.

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Relevance Theories of Dividend

Relevance theory of dividends states that a well-reasoned dividend policy can positively influence a firm’s position in the stock market. Higher dividends will increase the value of a stock, whereas low dividends will have the opposite effect.

A well-thought-out dividend policy can have a favourable impact on a company’s stock market performance. Dividends are becoming more and more of a reality as a measure of an organisation’s long-term prosperity.

Walter’s Model

According to James Walter, a company’s dividend policy always has an impact on its goodwill. According to Walter, the link between the firm’s return on investment (or internal rate of return) and the cost of capital (or necessary rate of return) is reflected in dividend policy. Assume the internal rate of return is r and the cost of equity capital is k. Then there are the following scenarios for each given company:

When r > k, this is the first case.

Growth businesses are defined as those with a r > k. Their ideal dividend policy is reinvesting the whole profit of the corporation. As a result, the dividend payment ratio is zero. This would also increase the company’s stock market valuation.

Case 2: When r < k

R k companies do not provide beneficial investment options. The best dividend strategy for these companies is to distribute all of their profits as dividends. When dividends are available at a greater rate, shareholders might use them to get them in other ways. In this scenario, a 100% dividend payout ratio would maximise the value of the equity shares.

When r = k, there is a third case.

It makes no difference whether a corporation with r = k keeps or distributes its earnings. In this situation, a change in dividend rates would have no effect on the share price. As a result, there is no ideal dividend policy for such businesses.

Model Assumptions Based on Walter’s Approach

• The company’s full funding is derived from retained earnings. It does not rely on debt or fresh equity capital as a source of funding.
  
  
• (Additional investment has no effect on the firm’s business risk. The firm’s internal rate of return and cost of capital stays unchanged as a result.
  
  
• Earnings Per Share (EPS) and Dividend Per Share (DPS) are initially fixed. The EPS and DPS values vary depending on the model, but any given values are expected to remain constant.
  
  
• The company has a lengthy history.

Criticism

The idea that investments are funded from the inside is incorrect. Financing is also obtained from other sources. In an organisation, the r/k ratio does not remain constant. r rises in lockstep with investment. Earnings and dividends are not taken into account when calculating the value. It is impossible to forecast if a company will last a long time.

Gordon’s Model

Gorden offered a model similar to Walter’s, claiming that dividends are important and that a company’s payouts impact its value. Gorden’s model is distinguished by the fact that the value of a dollar in dividend income exceeds the value of a dollar in capital gain. This is because future payouts are discounted at a higher rate due to the uncertainty of the future.

The market value of a share, according to Gorden, is equal to the present value of a future stream of dividends. The Gordon Growth Model (GGM) is used to calculate a stock’s intrinsic value based on a sequence of dividends that rise at a consistent pace in the future. It is a common and basic Dividend Discount Model (DDM) option. The GGM solves for the present value of an endless sequence of future payouts, assuming that dividends grow at a constant rate in perpetuity. Because the model implies a steady growth rate, it is often only used to corporations with consistent dividend-per-share growth rates.

The model evaluates a company’s stock based on the premise that payments to common equity owners would rise at a constant rate. Dividends Per Share (DPS), dividend growth rate and needed Rate of Return (RoR) are the three main inputs in the model. The GGM seeks to evaluate a stock’s fair value regardless of market conditions, taking into account dividend distribution considerations as well as the market’s predicted returns. If the model’s value is more than the current trading price of shares, the stock is deemed cheap and should be purchased and vice versa.

Dividends per share are the annual payments a firm provides to its common equity owners and the dividend growth rate is the percentage increase in dividends per share from one year to the next. The necessary rate of return is the minimal rate of return that investors are prepared to accept when purchasing a company’s shares and it is calculated using a variety of techniques.

The GGM assumes that a corporation survives indefinitely and provides constant dividends per share. The model takes an endless sequence of dividends per share and discounted them back into the present using the needed rate of return to determine the value of a company.

The formula is based on the mathematical principles of an endless sequence of rising integers.

P= D1 / r−g

Where:
P = Current stock price
g = Constant growth rate expected for dividends, in perpetuity
r = Constant cost of equity capital for the company (or RoR)
D1 = Value of next year’s dividends

Consider the case of a corporation whose stock is now selling at $110 per share. This corporation needs an 8% minimum rate of return (r) and will pay a $3 dividend per share (D1) next year, which is predicted to grow by 5% yearly (g).

The stock’s intrinsic value (P) is computed as follows:

P = $3 / .08 − .05 = $100

The shares are presently overpriced by $10 in the market, according to the Gordon growth model.

M-M Model

According to the Modigliani-Miller theorem (M&M), a firm’s market value may be accurately determined as the present value of its expected future profits and its underlying assets, regardless of the capital structure of the company.

The thesis contends that, under certain assumptions, it is unimportant whether a business supports its expansion by borrowing, issuing stock shares or reinvesting earnings.

The idea, which was created in the 1950s, has had a big influence on corporate finance.

There are only three methods for businesses to obtain capital to fund their operations and support development and expansion. They may borrow money by securing loans or issuing bonds, investing their earnings back into their business or issuing new stock to investors.

The Modigliani-Miller theorem contends that a company’s actual market worth is unaffected by the option or combination of options that it selects.

One of the theorem’s two creators, Merton Miller, uses an illustration to describe the theory’s underlying idea in his book Financial Innovations and Market Volatility:

“Imagine the company as a huge container of full milk. The milk may be sold by the farmer unaltered. Or he may separate the cream and sell it for much more money than whole milk would get. (That is the equivalent of a company selling expensive, high-yield debt products.) Of course, the farmer would still have skim milk, which has a low butterfat concentration and is sold for a considerably lower price than whole milk. That is equivalent to the equity with a lever. According to the M & M argument, whole milk and skim milk would cost the same amount if there were no separation expenses (and, of course, no government dairy assistance programmes).”

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What is Bonus Shares?

Bonus shares are typically issued to shareholders in order to boost the liquidity of the stock as well as to lower the stock price to make it more accessible to investors. Bonus shares are fully paid extra shares issued to current shareholders by a corporation.

Bonus shares are additional shares given to the current shareholders without any additional cost, based upon the number of shares that a shareholder owns. These are company’s accumulated earnings which are not given out in the form of dividends but are converted into free shares.

The basic principle behind bonus shares is that the total number of shares increases with a constant ratio of number of shares held to the number of shares outstanding. For instance, if Investor A holds 200 shares of a company and a company declares a 4:1 bonus, that is for every one share, he gets 4 shares for free. That is a total of 800 shares for free and his total holding will increase to 1000 shares.

Companies issue bonus shares to encourage retail participation and increase their equity base. When price per share of a company is high, it becomes difficult for new investors to buy shares of that particular company. An increase in the number of shares reduces the price per share. But the overall capital remains the same even if bonus shares are declared.