DIVIDEND: Dividends are payments made by a corporation to its

shareholder members. It is the portion of corporate profits paid out to

stockholders. When a corporation earns a profit or surplus, that money can be

put to two uses: it can either be re-invested in the business (called retained

earnings), or it can be paid to the shareholders as a dividend. Many

corporations retain a portion of their earnings and pay the remainder as a

dividend.

For a joint stock company, a dividend is allocated as a fixed amount per share.

Therefore, a shareholder receives a dividend in proportion to their

shareholding. For the joint stock company it is the division of an asset among

shareholders. Public companies usually pay dividends on a fixed schedule, but

may declare a dividend at any time, sometimes called a special dividend to

distinguish it from a regular one.

Cooperatives, on the other hand, allocate dividends according to members'

activity, so their dividends are often considered to be a pre-tax expense.

Forms of payment:

(1) Cash dividends are those paid out in the form of a cheque. Such dividends

are a form of investment income and are usually taxable to the recipient in the

year they are paid. This is the most common method of sharing corporate

profits with the shareholders of the company. For each share owned, a declared

amount of money is distributed. Thus, if a person owns 100 shares and the cash

dividend is $0.50 per share, the person will be issued a cheque for $50.

(2) Stock or scrip dividends are those paid out in form of additional stock

shares of the issuing corporation, or other corporation (such as its subsidiary

corporation). They are usually issued in proportion to shares owned (for

example, for every 100 shares of stock owned, 5% stock dividend will yield 5

extra shares). If this payment involves the issue of new shares, this is very

similar to a stock split in that it increases the total number of shares while

lowering the price of each share and does not change the market capitalization

or the total value of the shares held (see also Stock dilution).

(3) Property dividends are those paid out in the form of assets from the

issuing corporation or another corporation, such as a subsidiary corporation.

They are relatively rare and most frequently are securities of other companies

owned by the issuer, however they can take other forms, such as products and

services.

(3) Other dividends can be used in structured finance. Financial assets with a

known market value can be distributed as dividends; warrants are sometimes

distributed in this way. For large companies with subsidiaries, dividends can

take the form of shares in a subsidiary company. A common technique for

"spinning off" a company from its parent is to distribute shares in the new

company to the old company's shareholders. The new shares can then be traded

independently.

Dates:

Dividends must be “declared” by a company’s Board of Directors each time

they are paid. For public companies, there are four important dates to

remember regarding dividends.

The declaration date is the day the Board of Directors announces its intention

to pay a dividend. On this day, a liability is created and the company records

that liability on its books; it now owes the money to the stockholders. On the

declaration date, the Board will also announce a date of record and a payment

date.

The in-dividend date is the last day, which is one trading day before the ex-

dividend date, where the stock is said to be cum dividend (‘with dividend’). In

other words, existing holders of the stock and anyone who buys it on this day

will receive the dividend, whereas any holders selling the stock lose their right

to the dividend. After this date the stock becomes ex dividend.

The ex-dividend date (typically 2 trading days before the record date for U.S.

securities) is the day on which all shares bought and sold no longer come

attached with the right to be paid the most recently declared dividend. This is

an important date for any company that has many stockholders, including those

that trade on exchanges, as it makes reconciliation of who is to be paid the

dividend easier. Existing holders of the stock will receive the dividend even if

they now sell the stock, whereas anyone who now buys the stock will not

receive the dividend.

The payment date is the day when the dividend checks will actually be mailed

to the shareholders of a company or credited to brokerage accounts.

Dividend-reinvestment plans: Some companies have dividend reinvestment

plan, or DRIPs. These plans allow shareholders to use dividends to

systematically buy small amounts of stock, usually with no commission and

sometimes at a slight discount. In some cases the shareholder might not need to

pay taxes on these re-invested dividends, but in most cases they do.

DIVIDEND POLICY: Dividend policies are the regulations and guidelines

that companies develop and implement as the means of arranging to make

dividend payments to shareholders. Establishing a specific dividend policy is to

the advantage of both the company and the shareholder. In order to make sure

the policy is workable, a company should develop a viable policy and then run

this policy through a number of test scenarios in order to determine what

impact the dividend policy would have on the operation of the business.

OBJECTIVES OF DIVIDEND POLICIES: Dividend policy has a effect of

dividing its net earnings into two parts: retained earnings and dividends. The retained

earnings provide funds to finance the firm’s long-term growth. Dividends are paid in

cash. A firm, which intends to pay dividends, will have to use external source of

financing like issue of debt and equity. Thus dividend policy of a firm has its effect on

both the long term financing and wealth of shareholders.

Firms need for funds: - When dividend decision is treated as financing decision, the

net earnings are considered as a source of long-term funds. The firm grows at a faster

rate when it accepts highly profitable investment projects. External equity could be

raised to finance investment but retained earning are preferred because unlike external

equity they do not involve any flotation cost. The distribution of cash dividends

causes a reduction in internal funds available to finance the profitable investment

opportunities and consequently, either constrain the growth or require the firm to find

other costly source of financing. Thus the firm may retain their earning as a part of

long term financing decision. The dividends will be paid to shareholders when a firm

cannot profitably reinvest earnings. With this approach, dividend decision is viewed

merely as a residual decision.

Shareholders need for income:- Because of market imperfection and uncertainty,

shareholders may prefer the near dividends to the future dividends and capital gains.

Thus, the payment of dividends may significantly the market price of share. Higher

dividends may significantly increase the value of share and low dividends may reduce

the value. It is believed by some that in order to maximize the wealth under

uncertainty, the firm must pay enough dividends to satisfy investors. Investors in high

tax brackets, on the other hand, may prefer to receive capital gains rather than

dividends. Their wealth will be maximized if firm retained earnings rather than

distributing them. Thus there should be proper balance between these two approaches.

Management should develop a dividend policy, which divides the net earnings into

dividends and retained earning in an optimum way to achieve the objective of

maximizing the wealth of shareholders.

PRACTICAL CONSIDERATION IN DIVIDEND POLICY:-

Firms investment opportunities and financial needs.

Shareholders expectations.

Constrains on paying dividends

Stability of dividends

Forms of dividends

FIRMS INVESTMENT OPPORTUNITIES AND FINANCIAL NEEDS:-

Firms form dividend policy to have maximum financial flexibility and avoid

financial frictions and costs of raising external funds. Growth firms have large

number of investment opportunities requiring substantial amount of funds. Hence

they prefer retention of earning over payment of dividend. For matured firms,

investment opportunities often occur infrequently. These firms may distribute

most of their earnings. The retained earnings when they do not have investment

opportunities, may be invested in short term securities yielding nominal returns.

Retained earning are used as a source of internal financing only when a company

has profitable investment opportunities. If shareholders themselves have better

investment opportunities, the earnings should be distributed to them so that they

may be able to maximize their wealth. When the company has an internal rate of

return greater than the return required by shareholders, it would be to the

advantage of shareholders to allow the investment of earning by the company.

When the company does not have highly profitable opportunities and earns a rate

on investment, which is lower than the rate required by shareholders, it is not in

the interest of shareholders to retain earnings.

Companies prefer to retain earning because issuing new share capital is

inconvenient as well as involve floatation costs. If company raises debt the

financial obligation and the risk will increase. Thus directors neither follow a

practice of paying 100% dividends nor a practice of retaining 100% earning.

A company has target payout ratio. In the absence of profitable investment

opportunities, it can pay some extra dividends but still retaining some earning for

continued existence of the enterprise. Though shareholders are owners of the

company and directors should follow a policy desired by them. Shareholders are

the residual claimants of the earning of the company. Directors must retain some

earning, whether or not profitable investment opportunity exists, to maintain the

company as sound and solvent enterprise and to have financial flexibility.

Depending on the needs to finance their long-term investment opportunities,

companies follow different dividend policies. Mature companies that have fewer

investment opportunities may generally have high payout ratio. The share prices

of such companies are very sensitive to dividend changes. Growth companies

have plenty of investment opportunities and hence they may have low payout

ratios. They are continuously in need of funds to finance their fast growing fixed

assets. The distribution of funds reduces the funds of the company. Therefore

sometimes growth companies retain most of their earning and issue bond shares,

regularly or from time to time, to satisfy the dividend need of shareholder. These

companies would slowly increase the amount of dividends as the profitable

investment opportunities start fading.

SHAREHOLDERS EXPECTATIONS:- Directors decide the distribution of

earnings of a company. Shareholders are the legal owners of the company, and the

directors are appointed by them, are their agents. Therefore directors give due

importance to the expectations of shareholders in the matter of dividend decision.

Shareholders preference for dividends or capital gains may depend on their

economic status and the effect of tax on dividend and capital gains. In most

countries dividend income is taxed at a higher than the capital gains.

In closely held company, the body of the shareholders is small and homogeneous

and management usually knows the expectation of shareholders. Therefore, they

can easily adopt a dividend policy, which satisfies most of shareholders. If most of

shareholders are I high tax brackets and have a preference for capital gains to

current dividend incomes, the company can establish a dividend policy of paying

sufficient dividends and retaining the earnings within the company.

In widely held companies, the number of shareholders is very large, they are

dispersed and may have diverse desires regarding dividends and capital gains. So

it is not possible to follow a dividend policy, which equally satisfies all

shareholders. They may follow a dividend policy, which serves the purpose of

dominating group, but does not completely neglect the desires of others. In this

shareholders are widely divided into four groups: small, retired, wealthy and

institutional shareholders.

Small shareholders are not the frequent purchasers of the shares. They hold small

number of shares. They purchase shares only when their saving permits. Retired

and old persons generally invest in shares to get a regular income. These select

companies that have a history of paying regular and liberal dividends. Retired

person having some source of income may be interested in capital gains as well.

Wealthy investors are concerned about the dividend policy followed by the

company. They have definite investment policy of increasing their wealth and

minimizing taxes. They prefer a dividend policy of retaining earning and

distributing bonus shares. The wealthy shareholders are dominating in a company

and are able to influence the composition of board of directors by their significant

voting rights. Institutional investors purchase a large block of shares to hold

them for relatively longer period of time. They are not concerned about with

personal income tax but with profitable investments. Most of them avoid

speculative issues, seek diversification in their investment portfolio and favour a

policy of regular cash dividend payments.

The interests of various shareholders groups are in conflict. So board of directors

should consider two points. First, the board of directors should adopt a dividend

policy, which gives some consideration to the each groups comprising a

substantial proportion of shareholders. Second, a dividend policy once formed

should be continued as long as it does not interferes with the financing need of the

company. Investors who consider the dividend policy in accord with their

investment requirement. If a company suddenly changes its dividend policy, it

may work to the detriment of these shareholders. Thus an established dividend

policy must be changed slowly and after having analysed its probable effect on

existing shareholders.

CONSTRAINS ON PAYING DIVIDENDS:- The company’s decision

regarding the amount of earning to be distributed as dividends depend on legal

and financial constrains.

Legal restrictions The dividend policy of a firm has to evolve within the legal

framework and restrictions. The directors are not legally compelled to declare

dividends. The legal rules act as boundaries within which a company can operate

in terms of paying dividends. Acting within these boundaries, a company will

have to consider many financial variables and constrains in deciding the amount

of earnings to be distributed as dividends.

Liquidity:- the cash position of firm is an important consideration in paying

dividends; the greater the cash position and overall liquidity of a company, the

greater will be its ability to pay dividends. A mature company is generally liquid

and is able to pay a large amount of dividends. Growing firms face a problem of

liquidity. Even if they make good profits, they continuously need fund for

financing growing fixed assets and working capital so they follow conservative

dividend policy

Financing condition and borrowing capacity: A high degree of financial

leverage makes a company quite vulnerable to changes in earnings, and also it

becomes quite difficult to raise funds externally for financing its growth. Thus

financially leveraged company is expected to retain more to strengthen its equity

base. However a company with steady growing earning and without much

investment opportunities may follow a high dividend payment policy. Financial

flexibility includes the firms ability to access external funds at a later date. The

firm may loose the flexibility and capacity of raising external funds to finance

growth opportunities in future.

Access to the capital market: easy accessibility to the capital market provides

flexibility to management in paying dividends as well as in meeting the corporate

obligations. The greater is the ability of firm to raise funds in the capital markets,

greater will be its ability to pay dividends even if it is not liquid.

Restrictions in loan agreement: lenders may generally put restrictions on

dividend payment to protect their interest when the firm is experiencing low

liquidity. When these restrictions are put, the company is forced to retain earning

and have low payout.

Inflation: When prices rise, funds equal to depreciation set aside would not be

adequate to replace assets or to maintain the capital intact. To maintain the capital

intact and preserve their earning power, firms may avoid paying dividends. Some

companies may follow paying more dividends during high inflation in order to

protect the shareholders from the erosion of real value dividends.

Control: when company pays large dividends it has to issue new shares to raise

funds for investment purposes. The control of existing shareholders will be diluted

if they cannot buy additional shares. Under these circumstances, the payment of

dividends may be withheld and earnings may be retained to finance firms

investment opportunities.

STABILITY OF DIVIDENDS: - means regularity in paying some dividends

annually. Three forms of such stability may be distinguished:

Constant dividend per share or dividend rate

Constant payout

Constant dividend per share plus extra dividend

Constant dividend per share or dividend rate: In india companies

announce dividend as a percent of the paid up capital per share. This can

be converted into dividend per share. When the company reaches a new

levels of earnings and expects to maintain them, the annual dividend per

share or dividend rate must be increased. It is easy to follow this policy

when earnings are stable. In fluctuations it is difficult to maintain such

policy. In practice when a company retains earnings in good years, it

earmarks its surplus as dividend equalization reserve. These are invested

in current assets so that they may be easily converted into cash when

needed. Those investors who have dividends as the only source of their

income may prefer constant dividend policy. This helps in stabilizing the

market price of share.

Constant payout: The ratio of divident to earning is known as payout

ratio. Some companies pay a fixed percentage of net earning every year.

With this policy the amount of dividends will fluctuate in direct

proportion to earning. This policy is related to a company’s ability to pay

dividends. If the company incurs losses then no dividends shall be paid

regardless of desires of shareholders. This policy does not put any

pressure on company’s liquidity since dividends are distributed only when

company has profits.

Constant dividend per share plus extra dividend: companies with

fluctuating earnings, the policy to pay minimum dividend per share is

desirable. Paying extra dividend in period of prosperity. This policy

enable a company to pay a constant amount of dividend regularly without

a default and allows a great deal of flexibility.

Merits of stability of dividends: several advantages are:-

Resolution of investors uncertainity.

Investors desire for current income.

Institutional investors requirement.

Raising additional finances.

Danger of stability of dividends: the greatest danger in adopting a stable dividend

policy is that once it has established it cannot be changed without seriously affecting

investors attitude and the financial standing of the company.

FORMS OF DIVIDEND: different forms of dividend are:

cash dividend

bonus shares (stock dividend)

Cash dividend:- companies mostly pay dividends in cash. A company should have

enough cash in its account when cash dividends are declared. If it does not have

enough cash balance, arrangements should be made to borrow funds. While following

stable dividend policy it should prepare a cash budget for the coming period. It is

relatively difficult to make cash planning in anticipation of dividend needs when an

unstable policy is followed. Both the total assets and net worth of company are

reduced when the cash dividend is distributed. The market price of share drops in

most cases by amount of cash dividend distributed.

Bonus shares:- Issue of bonus shares is the distribution of shares free of cost to the

existing shareholders. In India bonus shares are issued in addition to cash dividend.

Issuing bonus shares increases the number of outstanding shares of the company. The

bonus shares are distributed proportionately to the existing shareholder. Thus there is

no dilution of ownership. The declaration of the bonus shares will increase the paid up

share capital and reduce the reserve and surplus. The total net worth is not affected by

the bonus issue. In fact the bonus issue represents a recapitalization of reserves and

surplus. It is merely an accounting transfer from reserves and surplus to paid up

capital.

Advantages of bonus shares:- bonus shares do not affect the wealth of shareholders.

ADVANTAGES OF BONUS SHARE TO SHAREHOLDERS:-

Tax benefit- When a shareholder receives cash dividend from company, this is

included in his ordinary income and taxed at ordinary income tax rate. But the receipt

of bonus shares by shareholders is not taxable as income. Shareholder can sell the

new shares received and pay capital gain taxes, which are usually less than the income

taxes on the cash dividends.

Indication of higher future profits- the issue of bonus shares is normally interpreted

by shareholders as an indication of higher profitability. When the profits of company

do not rise, and it declares a bonus issue, the company will experience a dilution of

earnings as a result of additional shares outstanding. Thus bonus shares convey

information that may have favorable impact on value of shares.

Future dividends may increase- If the company has been following a policy of

paying fixed amount of dividend per share and continues it after declaration of bonus

issue, the total cash dividends of the shareholders will increase in the future.

Psychological value- declaration of bonus issue may have favorable psychological

effect on shareholders. They also associate with the prosperity of the company.

Because of these positive aspects of the bonus issue, the market usually receives it

positively. This tends to increase the market interest in the company’s shares. Thus

supporting or raising its market price.

ADVANTAGES OF BONUS SHARES TO COMPANY:-

Conservation of cash- The declaration of bonus issue allows the company to declare

a dividend without using up cash that may be needed to finance the profitable

investment opportunities within the company. The company is thus able retain

earnings and at the same time satisfy the desires of shareholders to receive dividend.

The use of bonus issue represents a compromise, which enables directors to achieve

both these objectives of dividend policy. The company could retain earnings without

declaring bonus share issue.

Only means to pay dividend under financial difficulty and contractual

restrictions- Under the situations of financial stringency or contractual constrain in

paying cash dividend, the bonus issue is meant to maintain the confidence of

shareholders in company.

LIMITATIONS OF BONUS SHARES:- bonus shares have following limitations:

Shareholders wealth remain unaffected

Costly to administer

Problem of adjusting EPS and P/E ratio

The declaration of bonus shares is a method of capitalizing the past earning of the

shareholders. Thus it is a formal way of recognizing earning which the shareholders

already own. It merely divides the ownership of the company into large number of

share certificates. The disadvantage of bonus issues from the company’s point of view

is that they are more costly to administer than cash dividend. The bonus issue can be

disadvantageous if the company declares periodic small bonus shares.

Conditions for the issue of bonus shares- The maximum bonus share ratio is 1:1 i.e.

one bonus share for one fully paid up share held by existing shareholders. However

two criteria are required to be satisfied within the limit of the maximum ratio. They

are:-

Residual ratio criterion

Profitability criterion

Residual ratio criterion- It requires that reserve remaining after the amount

capitalized for bonus issue should be at least equal to 40% of the increased paid-up

capital. Redemption reserve and capital reserve on account of assets revaluation are

excluded while investment allowance reserve is included in computing the minimum

residual reserve.

(Pre bonus reserve)- Pre bonus paid up capital * Bonus ratio >= 0.4(1+Bonus ratio)*

Pre bonus paid up capital

Profitability criterion- It requires that 30 per cent of the previous 3 years average pre

tax profit (PBT) should be at least equal to 10% of the increased paid up capital.

0.3 * 3 yrs average PBT >= 0.1 (1+Bonus ratio) * Pre bonus paid up capital

SHARE SPLIT:- Share split is a method to increase the number of outstanding

shares through a proportional reduction in par value of the share. A share split affects

only the par value and the number of outstanding shares; the shareholders total funds

remain unaltered.

Reasons of share split:-

To make trading in shares attractive

To signal the possibility of higher profits in the future

To give higher dividends to shareholders

To make shares attractive- The main purpose of a stock split is to reduce the market

price of share in order to make it attractive to investors. With the reduction in market

price of share, the shares of company are placed in a more popular trading range.

Thus the reduction in the market price caused by share split motivates more investors

particularly those with small savings to purchase the shares. This helps in increasing

the marketability and liquidity of market shares.

Indication of higher future profits- the share splits are used by the company

management to communicate to investors that the company is expected to earn higher

profits in future. The market price of high growth firm shares increases very fast.

Increased dividends- when the share is split, seldom does a company reduce or

increase the cash dividend per share proportionately. However, the total dividends of

a shareholder increase after share split. The increased dividends may favourably affect

the after split market price of the share. It should be noted that the share split per se

has no effect on the market price of share.

REVERSE SPLIT:- Under a situation of falling price the company may want to

reduce the number of outstanding shares to prop up the market price per share. The

reduction of the number of outstanding shares by increasing per share value is known

as reverse split.

BUYBACK OF SHARES:- The buyback of shares is repurchase of its own shares by

a company. Until recently the buyback of shares by companies in India was prohibited

under section 77 of Indian Companies act. In India the following conditions apply in

case of buy back of shares:

A company buying back its share will not issue fresh capital, except bonus

issue, for the next 12 months.

The company will state the amount to be used for the buyback of share and

seek prior approval of shareholders.

The buyback of shares can be affected only utilizing the free reserves, viz.,

reserves not specifically earmarked for some purpose.

The company will not borrow funds to buyback shares.

The shares brought under the buyback scheme will be extinguished and they

cannot be reissued.

Methods of shares buyback:- There are two methods of the share buyback in

India. First, a company can buy its shares through authorized brokers on the open

market. Second, the company can make a tender offer, which will specify the

purchase price, the total amount and the period within which the shares will be

brought back.

Effects of shares buyback:- It is believed that the buyback will be financially

beneficial to the company, the buying shareholders and the remaining

shareholders. 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 is expected to remain the same after the buyback.

Advantages of buyback:-

RETURN OF SURPLUS CASH TO SHAREHOLDERS- The buying

shareholders will benefit since the company generally offer a price higher

than the current market price of the share.

INCREASE IN SHARE VALUE:-When the company distributes the

surplus cash, its operating efficiency and P/E ratio remains intact. With

reduced number of shares, EPS increases and share price also increases.

INCREASE IN TEMPORARILY UNDERVALUED SHARE PRICE:-

Companies may buyback share at higher prices to move up the current

share prices.

ACHIEVING THE TARGET CAPITAL STRUCTURE:- If a company

has high proportion of equity in its capital structure, it can reduce equity

capital by buying back its share.

CONSOLIDATING CONTROL:- the promoters of company do not sell

their shares to the company rather make the buyback attractive for others.

Their proportionate ownership increases.

TAX SAVING BY COMPANIES:-Dividends payments are taxable in the

hands of companies at 12.5%. They will avoid paying dividend taxes if

they compensate shareholders through the share buyback.

PROTECTION AGAINST HOSTILE TAKEOVERS:- In hostile takeover,

a company may buyback its shares to reduce the availability and make

takeover difficult.

Drawbacks of the buyback:-

Not an effective defense against takeover

Shareholders do not like the buyback

Loss to the remaining shareholders

Signal of low growth opportunities