DIVIDEND POLICY

PRESENTED BY, MARYANN RAPHAEL ROLL NO:32

INTRODUCTION
Dividend is a reward of shareholders for investments made by them in the shares of the company. So dividend policy will affect the long term financing and wealth of shareholders. As a result, the firms decision to pay dividends must be reached in such a manner so as to equitably apportion the distributed profits and retained earnings. The company should distribute dividends in such a way that shareholders are getting fair return on their investment and rest of the profit for growth and survival of the firm.

DIVIDEND DECISION AND VALUATION OF FIRMS

The value of the firm can be maximized if the wealth of shareholders is maximized. According to school to thought, dividend decision doesnt affect the shareholders wealth and valuation of firm. On other hand according to other school of thought, dividend decision affect the shareholders wealth and valuation of firm. The views of two schools of thought are under two groups:

Relevance concept
Irrelevance concept

THEORY OF RELEVANCE
The theory holds that dividend decisions affect the value of the firm. According to the advocates, dividends communicate information to the investors about the firms profitability and hence dividend decision becomes relevant. Those firms which pay higher dividends will have greater value as compared to those which do not pay dividends or have a lower dividend pay out ratio .

WALTERS APPROACH
Walters supports the doctrine that dividend decisions are relevant and affect the value of the firm. The relationship between the internal rate of return earned by the firm and its cost of capital is very significant in determining the dividend policy to sub serve the ultimate goal of maximizing the wealth of the shareholders. According to him, if the firm earns a higher rate of return on its investment than the required rate of return, the firm should retain earnings.

Such firms are termed as growth firms and the optimum pay out would be zero in this case. This would maximize the value of shares. In case of declining firms which do not have profitable investments, the shareholders would stand to gain if the firm distributes its earnings. For such firms the optimum pay out would be 100% and the firms should distribute the entire earnings as dividends. In case of normal firms ,the dividend policy will not affect the market value of shares as the shareholders will get the same return from the firms as expected by them. For such firms, there is no optimum dividend pay out and the value of the firm would not change with the change in dividend rate.

ASSUMPTIONS OF THE APPROACH

The investments of the firm are financed through retained earnings only and firm doesnt use external source of funds. The internal rate of return and the cost of capital of the firm are constant.

Earnings and dividends do not change while determining the value.

The firm has a very long life.

CRITICISM OF THE APPROACH

Investments are financed through retained earnings only .

Firms do raise funds by external financing. The internal rate of return does not remain constant.

The rate of return also changes with increasing investment.

The cost of capital will remain constant also does not hold good as the firms risk pattern does not remain constant.

GORDONS APPROACH
Gordon suggested that dividends are relevant and the dividend decision of the firm affects its value .The market value of a share is equal to the present value of the future stream of dividends.

ASSUMPTIONS
The firm is an all equity firm. No external financing is available or used. Retained earnings represent the only source of financing investment programs. The rate of return on firms investment is constant. The firm has perpetual life.

 Corporate taxes do not exist.

The cost of capital for the firm remains constant and it is greater than the growth rate.
The retention ratio once decided upon is constant. Thus the growth rate of the firm is also constant.

THEORY OF IRRELEVANCE

RESIDUAL APPROACH
According to this theory, dividend decision has no effect on the wealth of the shareholders or the prices of the shares and hence it is irrelevant so far as the valuation of the firm. This theory regards dividend decision merely as a part of financing decision because the earnings available may be retained in the business for re- investment. But if the funds are not required in the business they be distributed as dividends. Thus the decision to pay dividends or retain the earnings may be taken as a residual decision.

MODIGLIANI AND MILLER APPROACH

According to them, dividend policy has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy. The splitting of earnings between retentions and dividends may be in any manner the firm likes, does not affect the value of the firm.

ASSUMPTIONS
There are perfect capital markets. Investors behave rationally.

The firm has a rigid investment policy.

There are no floatation and transaction costs. Information about the company is available to all without any cost.

 No investor is large enough to effect the market price of shares.

There are no either taxes or there are no differences in the tax rates applicable to dividends and capital gains.
There is no risk or uncertainty in regard to the future of the firm .

CRITICISMS
Perfect capital markets does not exist. Information about the company is not available to all the persons.

The firms have to incur flotation costs while issuing securities.

 Taxes do not exist and there is normally different tax treatment for dividends and capital gains. The firms do not follow a rigid investment policy. Investors have to pay brokerage, fees etc. while doing any transaction. Shareholders may prefer current income as compared to further gains.

DETERMINANTS OF DIVIDEND POLICY

1) LEGAL RESTRICTIONS

According to legal provisions dividend can be paid only out of current profits or past profits after providing for deprecation or out of money provided by government for payment of dividends in pursuance of a guarantee given by the government.
2) MAGNITUDE AND TREND OF EARNINGS As the dividends can be paid out only out of present or past years profits, earnings of a company fix the upper limits on dividends. The dividends should be paid out of current years earnings of the previous years become more or less a part of permanent investment in the business to earn current profits.

3)DESIRE AND TYPE OF SHAREHOLDERS

The directors should give the importance to the desires of shareholders in the declaration of dividends as they are representatives of shareholders. Desires of shareholders for dividends depend upon their economic status. There are a class of investors who view dividends as a source of funds to meet their day to day living expenses.to benefit such investors companies pay regular dividends. A wealthy investor in a high income tax bracket may not benefit by high current dividend incomes. Such investor may be interested in lower current dividends and high capital gains.

4) NATURE OF INDUSTRY

Certain industries have a comparatively steady and stable demand irrespective of the prevailing economic conditions. If earnings are uncertain, conservative policy should be followed. Such firms should retain a substantial part of their current earnings during boom period in order to provide funds to pay adequate dividends in the recession periods. Thus industries with steady demand of their products can follow a higher dividend pay out ratio while cyclical industries should follow a lower pay out ratio.

5) AGE OF THE COMPANY

A newly established concern has to limit payment of dividend and retain substantial part of earnings for financing its future growth and development while older companies which have established sufficient reserves can afford to pay liberal dividends. 6) Requirement of institutional investors The investors usually favor a policy of regular payment of cash dividends and stipulate their own terms with regard to payment of dividend on equity shares. 7) GOvERNmENTS ECONOmIC POLICy The dividend policy of the firm is to be adjusted to the economic policy of the government. Companies were allowed to pay dividends not more than 33% of the profits or 12% on paid up value of the shares whichever is lower.

8) FUTURE FINANCIAL REQUIREMENTS

The management of a concern has to reconcile the conflicting interests of shareholders and those of the companys financial needs. If a company has highly profitable investment opportunities it can convince the shareholders of the need for limitation of dividend to increase the future earnings and stabilize its financial position. But when profitable investment opportunities do not exist then the company may not be justified in retained substantial part of its current earnings.
9) TAXATION POLICY A high or low rate of business taxation affects the net earnings of company and thereby its dividend policy. Similarly a firms dividend policy may be dictated by the income tax status of its shareholders. If the dividend income of shareholders is heavily taxed being high income bracket, the shareholders may forego cash dividend and prefer bonus shares and capital gains.

10) INFLATION

Profits as arrived from the profits and loss account on the basis of historical cost have a tendency to be overstated in times of rise in prices due to over valuation of stock in trade and writing off depreciation on fixed assets at lower rates. As a result, when price rise, funds generated by depreciation would not be adequate to replace fixed assets and hence to maintain the same assets and capital intact ,substantial part of the current earnings would be retained.
11) CONTROL OBJECTIVES When a company pays high dividends out of its earnings, it may result in the dilution of both control and earnings for existing shareholders. As in case of a high dividend pay out ratio, the retained earnings are in significant and the company will have to issue new shares to raise funds to finance its future requirements. The control of the existing shareholders will be diluted if they cannot buy the additional shares issued by the company.

12) STABILITY OF DIVIDENDS Stability of dividends refers to payment of dividend regularly and shareholders prefer payment of such regular dividends. Some companies follow a policy of constant dividend per share which is most suitable to concerns whose earnings are expected to remain stable over a number of years or those who have built up sufficient reserves to pay dividends in the years of low profits while others follow a policy of constant pay out ratio i.e., paying a fixed percentage of net earnings every year may be supported by a firm because it is related to the firms ability to pay dividends and while there are some other who follow a policy of constant low dividend per share plus an extra dividend in the years of high profits which is suitable to the firm's having fluctuating earnings from year to year.

13) LIQUID RESOURCES

If a company does not have liquid resources , it is better to declare stock dividend i.e. issue of bonus shares to the existing shareholders. The issue of bonus shares also amounts to distribution of firms earnings among the existing shareholders without its cash position. Even if a firm has sufficient available profits to declare dividends , it may not be desirable to pay dividends if it does not have sufficient liquid resources.