Types of Dividend Policies

The size and frequency of dividend payments are critical issues in company policy. Dividend policy affects the financial structure, the flow of funds, corporate liquidity, stock prices, and the morale of stockholders. The finance manager plays an important role in the dividend policy. The objective of dividend policy is to maximize shareholder’s return so that the value of his investment is maximized. Shareholders’ return consists of two components: dividends and capital gains. Dividend policies has a direct impact on these components;

  1. A Low payout ratio may produce higher share price because it accelerates earnings growth. Investors of growth companies will realize their return mostly in the form of capital gains. Dividend yield – dividend per share divided by the market price per share will be low for such companies. The impact of dividend policy on future capital gains is, however, complex. Capital gains occur in distant future, and therefore, are considered uncertain. It is not certain that low payout ratio policy will necessary lead to higher prices in reality. It is quite difficult to clearly identify the effect of payout on share price.
  2. A high payout ratio means more current dividends and less retained earnings, which may consequently result in slower growth and perhaps lower market price per share.

Paying dividends involve outflow of cash. The cash availability for the payment of dividends is affected by firm’s investment and financing decisions. Thus, investment decisions affect dividend decisions. Dividend policies of diverse nature are available. Prominent of them are dealt with below.

  1. Policy of No Immediate Dividend: Generally, management follows a policy of paying no immediate dividend in the beginning of its life, as it requires funds for growth and expansion. In case, when the outside funds are costlier or when the access to capital market is difficult for the company and shareholders are ready to wait for dividend for sometime, this policy is justified, provided the company is growing fast and it requires a good deal of amount for expansion. But such a policy is not justified for a long time, as the shareholders are deprived of the dividend and the retained earnings built up which will attract attention of laborers, consumers etc. It would be better if the period of dividend is followed by issue of bonus shares, so that later on rate of dividend is maintained at a reasonable level.
  2. Regular or Stable Dividend Policy: When a company pays dividend regularly at a fixed rate, and maintains it for a considerably long time even though the profits may fluctuate, it is said to follow regular or stable dividend policy. Thus stable dividend policy means a policy of paying a minimum amount of dividend every year regularly. It raises the prestige of the company in the eyes of the investors. A firm paying stable dividend can satisfy its shareholders and can enhance its credit standing in the market. Not only that the dividend must be regularly paid but the dividend must be stable. It may be fixed amount per share or a fixed percentage of net profits or it may be total fixed amount of dividend on all the shares etc. The benefits of stable dividend policy are (1) it helps in raising long-term finance. When the company tries to raise finance in future, the investors would examine the dividend record of the company. The investors would not hesitate to invest in company with stable dividend policy. (2) As it will enhance the prestige of the company, the price of its shares would remain at a high level. (3) The shareholders develop confidence in management. (4) It makes long-term planning easier.
  3. Regular Dividend plus Extra Dividend Policy. A firm paying regular dividends would continue with its pay out ratio. But when the earnings exceed the normal level, the directors would pay extra dividend in addition to the regular dividend. But it would be named ‘Extra dividend’, as it should not give an impression that the company has enhanced rate of regular dividend, This would give an impression to shareholders that the company has given extra dividend because it has earned extra profits and would not be repeated when the business earnings become normal. Because of this policy, the company’s prestige and its share values will not be adversely affected. Only when the earnings of the company have permanently increased, the extra dividend should be merged with regular normal dividend and thus rate of normal dividend should be raised. Besides, the extra dividend should not be abruptly declared, but the shareholders should have some idea in advance, so that they may sell their shares, if they like. This system is not found in India.
  4. Irregular Dividend Policy: When the firm does not pay out fixed dividend regularly, it is irregular dividend policy. It changes from year to year according to changes in earnings level. This policy is based on the management belief that dividend should be paid only when the earnings and liquid position of the firm warrant it. This policy is followed by firms having unstable earnings, particularly engaged in luxury goods.
  5. Regular Stock Dividend Policy: When a firm pays dividend in the form of shares instead of cash regularly for some years continuously, it is said to follow this policy. We know stock dividend as bonus shares. When a company is short of cash or is facing liquidity crunch, because a large part of its earnings are blocked in high level of receivables or when the company is need of cash for its modernization and expansion program, it follows this policy. It is not advisable to follow this policy for a long time, as the number of shares will go on increasing, which would result in fall in earnings per share. This would adversely affect the credit standing of the firm and its share values will go down.
  6. Regular Dividend plus Stock Dividend Policy: A firm may pay certain amount of dividend in cash and some dividend is paid in the form of shares (stock). Thus, the dividend is split in to two parts. This policy is justified when (1) The company wants to maintain its policy of regular dividend and yet (2) It wants to retain some part of its divisible profit with it for expansion. (3) It wants to give benefit of its earnings to shareholders but has not enough liquidity to give full dividend in cash. All the limitations of paying regular stock dividends apply to this policy.
  7. Liberal Dividend Policy: It is a policy of distributing a major part of its earnings to its shareholders as dividend and retains a minimum amount as retained earnings. Thus, the ratio of dividend distribution is very large as compared to retained earnings. The rate of dividend or the amount of dividend is not fixed. It varies according to earnings. The higher is the profit, the higher will be the rate of dividend. In years of poor earnings, the rate of dividend will be lower. In fact, it is the policy of Irregular Dividend.

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Dividend Policies based on form of Dividend

From the point of view of form, dividend policies could be: cash dividend policy, scrip dividend policy or combined policy. Cash dividend policy stipulates that dividends are payable in cash only. This is the most predominant method. Indian laws recognize only this form as dividend. Scrip dividend policy underlies payment of dividend through issue of fully-paid-up bonus shares. Well established companies make bonus issues. Conservation of firm’s liquidity, to make the balance sheet to present a realistic picture of its capital base, to widen bases in the shares market, to finance expansion programmes, to enhance the corporate image, to lower the rate of dividend per share on future occasions and to get some tax benefits scrip dividend is issued. The combined policy, implies that both cash and scrip dividends are periodically declared by the company.

Dividend Policies based on stability of Dividend

From the stability point of view we have: fixed divided or varying payout ratio policy, varying dividend or fixed payout ratio policy, steadily changing dividend policy, target dividend payout policy and residual dividend policy. Fixed Dividend policy ensures that a constant dividend per share (DPS) is paid periodically. Shareholders are certain of their current dividend income can plan their financial activities accordingly. This policy implies that the payout ratio is changing and that a dividend equalization fund may be required. This policy might ensure a high and stable share price. Such a condition favors investors. Varying Dividend per share policy implies that the DPS fluctuates. Perhaps this may be due to that a constant payout ratio is adopted by the firm while its earnings fluctuate year after year. Share prices might fluctuate and speculation might build up.

A policy of steadily changing dividend per share is a good alternative to both the above policies. Here the DPS is not infinitely held constant or allowed to scale peaks and fall into troughs alternatively. On the other hand the DPS is gradually changing (increasing or decreasing). Unless and until an upswing in EPS is stabilized, DPS is not scaled up and similarly only when a down-swing in EPS is more or less constant, the DPS is scaled down. When an upswing in EPS is expected to be maintained for a reasonably long time, the DPS is scaled up.

A company may adopt, a policy of target payment ratio, wherein it fixes a payment ratio which it must reach over a period of time. This policy is also a via media to fixed and fluctuating dividend policies. There is another policy called residual dividend policy. Dividend is paid only when anything is left after meeting all investment needs. So, dividends would be very much fluctuating or mostly nil going hill up or valley down.

Dividend Policies based on Timing

From the timing point of view we have regular and irregular, interim and annual and, immediate and no-immediate dividend policies. Regular dividend policy implies that payment of dividend is a regular feature. The irregular dividend policy implies the opposite. Shareholders definitely prefer the former to the latter policy. Interim dividend policy is that the company declares dividend more man once in a year. As and when disposable profits are available dividend is declared. Annual dividend policy means that only once in a year dividend is paid Immediate dividend policy means that the company pays dividend right from establishment. It adds value to the company. No immediate dividend policy is one where the company does not start paying dividend until it has good earnings. To finance expansion, growth and diversification the internal funds may be used. Cost of fresh external capital may be high and that no-dividend policy is adopted. Generally, few companies adopt this policy. But they have to be very cautious in this regard.

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