Dividend Decision

Meaning and Definition of Dividend

Dividend is defined as the distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.

Dividend is a taxable payment declared by a company’s board of directors and given to its shareholders out of the company’s current or retained earnings, usually quarterly. Dividends are usually given as cash (cash dividend), but they can also take the form of stock (stock dividend) or other property. Dividends provide an incentive to own stock in stable companies even if they are not experiencing much growth. Companies are not required to pay dividends. The companies that offer dividends are most often companies that have progressed beyond the growth phase, and no longer benefit sufficiently by reinvesting their profits, so they usually choose to pay them out to their shareholders also called dividend payout.

Dividend Decision – An Important Financial Management Decision

Dividend decisions is an important aspect of corporate financial policy since they can have an effect on the availability as well as the cost of capital. Dividend decision determines the division of earnings between payments to shareholders and retained earnings. The Dividend Decision, in Corporate finance, is a decision made by the directors of a company about the amount and timing of any cash payments made to the company’s stockholders. The dividend decision, which consider the amount of funds retained by the company and the amounts to be distributed to the shareholders, is closely linked to both investment and financing decisions. For example the company with few projects should return the unused funds to shareholder by the way of paying more dividends. A company with several suitable projects that maintains high dividends will have to fund from external sources.

In the recent years, the decision what amount to retain and what amount to pay has become an important corporate decision. The management should take into account the expectation of the shareholders and the capital market when making dividend decision.

Relationship between Dividend Policy and Value of the Firm

One of the major decision areas of financial management in which the shareholders are also actively interested is the formulation of dividend policy. This decision involves the choice between distributing the earnings between the shareholders and retention by the company of such earnings. Since the principal objective of corporate financial management is to maximize the shareholders’ wealth or the market value of shares, the choice would be influenced by its effect on this objective. A vital question that would arise at this stage whether dividend policy pursued by a company has bearing on the market value of its equity shares. There is no clear cut answer to this question. In fact, it is one of the most controversial and unresolved issues in corporate finance. On this issue the opinions of the academicians are sharply divided into two schools of thought. One school of thought considers the extent of earnings distributed as dividends among equity shareholders as relevant to the market value of equity shares. The other school of thought argues that dividend policy is not a factor of enhancing the market value of equity shares.

Types of Dividend

  1. Interim Dividend: It is the dividend which is paid to the shareholders before the preparation of final accounts. Alternatively, it can be stated as dividend payment between two annual general meetings of the company. Interim dividend can be paid only when the board of directors is authorized by the articles of association to do so. A shareholders meeting is not necessary for declaration of interim dividend. At the middle of the financial year a company is in a position to estimate the profitability for the year. Based on the estimate, the company pays the interim dividend.
  2. Final Dividend: After the determination of divisible profit at the end of the financial year, the dividend declared as per provisions of the articles of association of the company is known as final dividend. The articles of association impart full authority to the directors to declare dividend. It is the discretion of the directors whether to declare dividend or not and if dividend is declared the rate at which such dividend is to be paid. The shareholders have no power to declare dividend or to fix up the rate unless the board has any such recommendation.

Some Basic Dividend Policies

In real life, a firm may practice any dividend policy based on the basic dividend policies. A dividend policy that a firm follows depends on a number of factors. Each firm must formulate its own dividend policy as per its needs. A few basic dividend policies which firms generally pursue are mentioned below:

  1. Constant Rate of Dividend: As per this policy, the firm pays a dividend at a fixed rate on the paid up share capital. If this policy is pursued, the shareholders are more or less sure on the earnings on their investment. This policy of paying dividend at a constant rate will not create any problem in those years in which the company is making steady profit. But paying dividend at a constant rate may face the trouble in the year when the company fails to earn the steady profit. Therefore, some of the experts opine that the rate of dividend should be maintained at a lower level if thus policy is followed.
  2. Constant Percentage of Earnings: A firm may pay dividend at a constant rate on earnings. Since payment of dividend depends on the current earnings, the payment of dividend will rise in the year the firm is earning higher profit and the dividend payment will be lower in the year in which the profit falls. Since fluctuations in profits lead to fluctuations in dividends, the principle adversely affects the price of the shares. As a result, the firm will find it difficult to raise capital from the external source.
  3. Stable Rupee Dividend plus Extra Dividend: Under this policy, a firm pays fixed dividend to the shareholders. In the year the firm is earning higher profits it pays extra dividend over and above the regular dividend. When the normal condition returns, the firm begins to pay normal dividend by cutting down the extra dividend.

Factors Influencing a Firm’s Dividend Decision

There are certain issues that are taken into account by the directors while making the dividend decisions:

  1. Free-cash flow
  2. Dividend clienteles
  3. Information signaling

The free cash flow theory of dividends

Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash that is surplus after it invests in all available positive net present value projects.

A key criticism of this theory is that it does not explain the observed dividend policies of real-world companies. Most companies pay relatively consistent dividends from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision

Dividend clienteles

A particular pattern of dividend payments may suit one type of stockholder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

A key criticism of the idea of dividend clienteles is that investors do not need to rely upon the firm to provide the pattern of cash flows that they desire. An investor who would like to receive some cash from their investment always has the option of selling a portion of their holding. This argument is even more cogent in recent times, with the advent of very low-cost discount stockbrokers. It remains possible that there are taxation- based clienteles for certain types of dividend policies.

Information signaling

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm’s future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends.

When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information that may provide a clue as to the firm’s future prospects. Managers have more information than investors about the firm, and such information may inform their dividend decisions. When managers lack confidence in the firm’s ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (eg. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers’ behavior to inform their decision to buy or sell the firm’s stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. This,in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.

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