Dividend refers to the portion of net income paid out to shareholders. It is paid in cash and/or stock for making investment and bearing risk. Dividend decision of the firm is yet another crucial area of financial management as it affects shareholders wealth and value of the firm. The percentage of earning paid out in the form of cash dividend is known as dividend payout ratio. A company may retain some portion of its earnings to finance new investment. The percentage of retained in the firm is called retention ratio. Dividend policy is an integral part of the firm’s financing decision as it provides internal financing. Dividend policy is concerned with determining the proportion of firm’s earnings to be distributed in the form of cash dividend and the portion of earnings to be retained. A firm has three alternatives regarding the payment of cash dividends:
- It can distribute all of its earnings in the firm of cash dividends,
- It can retain all of its earnings for reinvestment,
- It can distribute a part of earnings as dividend and retain the rest for reinvestment purpose.
When dividends are paid to the stockholders the firm’s cash is reduced. A firm may decrease its dividend payout and use the retained funds to expand its capacity, to pay off some of its debt or to increase investment. In this way, the firm’s dividend policy is closely related with the firm’s investment and financing decisions.
Determining the part of earnings to be distributed as dividends is a key decision that affects the value of firm’s common stock in the market place. Similarly, the retained earnings are considered to be the most convenient internal source available for financing corporate growth. Thus, every corporate firm should establish and implement an effective dividend policy that leads the firm to stockholders wealth maximization.
It should be recognized that a firm’s dividend payout ratio depends on many factors. For example, it may be affected by the volatility in firm’s cash flows and changing investment needs over time. If the firm’s cash flow is volatile, it may prefer to set a minimum level of regular cash dividends that can be maintained even at low profits. Similarly, if the firm has profitable investment opportunity it prefers to retain more amount by reducing dividend payout ratio.
Factors Affecting Dividend Policy of a Firm
A firm’s dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types of dividend. The following are the some major factors which influence the dividend policy of the firm.
- Legal requirements – There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment rule and insolvency rule.
- Firm’s liquidity position – Dividend payout is also affected by firm’s liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.
- Repayment need – A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.
- Expected rate of return – Expected rate of return also affects the dividend policy of the business firm If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.
- Stability of earning – If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.
- Desire of control – When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.
- Access to the capital market – If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm’s dividend payment capacity becomes high.
- Shareholder’s individual tax situation – For a closely held company, stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend gains.
Dividend Payment Procedures of a Firm
1. Declaration Date
The board of directors of the company announces that a specified amount of dividend will be paid to the stockholders. It is paid to the stockholders who will be on the record on the company’s record at some particular future date. The date on which directors meet and announce dividend is called declaration date. Generally, the dividend is announced as a percentage on the par value of the stock. However, in some cases, it can be the absolute amount as Rs.10 dividend per share.
2. Date of Record
Along with the dividend announcement, the board of directors also specifies a date of record. For example, if the board of directors meets on June10, 2010, and declares a 10 % cash dividend to the stockholders of record on September 15; the July 10 is called declaration date and the September 15 is called date of record. The company prepares a list of stockholders from the stock transfer book at the close of business on the date of record. All the stockholders of the record date are entitled to receive dividend as declared by the board. The new stockholders would receive dividend if the shareholders’ name is recorded in the shareholders registered on or before the date of record. But, if the company were notified of the transfer after the date of record, the old owner of the stock would receive the dividends.
3. Ex-dividend Date
There can be delay of several days from the time a transfer takes place to the time the firm is informed of the transfer. Therefore, shares transferred on, say September 12, would not generally recorded on the company’s book. In normal practice, the buyer and seller of the stocks have four business days to settle the transactions prior to the date of record. For example, if the date of record is September 15, the transaction must take place before September 11 to entitle the new holder to receive dividend. Thus, the date when the right to the dividend leaves the stock for new owner is called ex-dividend date. In our example if stock is bought on or after September 11, the new shareholder is not entitled to receive dividend. As a result of this, we normally expect that stock price will decline exactly by the amount of dividend per share on the ex-dividend date.
4. Payment Date
At the time of dividend announcement, the board of directors also specifies the date on which the payment of dividend is actually made and it is called the payment date. On this date the company actually pays the dividend to all the stockholders of the date of record.