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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